On Dec. 3, the Securities and Exchange Commission (SEC) adopted a new rule (Rule 2a-5) under the Investment Company Act of 1940 (the 1940 Act) that establishes an updated regulatory framework for fund valuation oversight practices affecting all registered investment companies and business development companies. Most significantly, the new rule permits a fund board to designate a “valuation designee” to perform the portfolio's fair valuation determinations, subject to the fund board's oversight. The valuation designee must provide, among other things, annual and quarterly reports to the fund board; assess and manage material risks associated with fair value determinations; select, apply and test fair value methodologies; and oversee and evaluate the use of pricing services. The valuation designee must be the adviser of the fund (and not a subadviser) or an officer of an internally managed fund.
Reporting and Oversight Requirements
The new rule specifically requires the fund board to oversee the valuation designee. The release notes that boards should use the appropriate level of scrutiny based on the fund's valuation risk, including the extent to which the fair value of the fund's investments depends on subjective inputs. Boards should periodically review the financial resources, technology, staff and expertise of the valuation designee, as well as the type, content and frequency of the reports they receive. Boards must request and review information as may be necessary to be informed of the process for determining fair value of fund investments, and if the board becomes aware of material matters, the board should take reasonable steps to see that they are addressed.
At a minimum, the valuation designee must make annual and quarterly written reports to the board. The quarterly reports must include any materials requested by the board and a summary of material fair value matters that occurred in the prior quarter (including any material changes in the assessment and management of valuation risks, any material changes to or deviations from fair value methodologies, and any material changes to the process for selecting and overseeing pricing services). The annual reports must contain an assessment of the adequacy and effectiveness of the valuation designee's process (including a summary of the results of testing) and an assessment of the adequacy of resources allocated to the process (including any material changes to the roles or functions of the persons responsible for determining fair value).
In addition, the new rule requires the valuation designee to provide a written notification to the board of the occurrence of any matter that materially affects the fair value of the designated portfolio within five business days after the valuation designee becomes aware of the matter. Examples of material matters include a significant deficiency or material weakness in the design or effectiveness of the fair value determination process or material errors in the calculation of net asset value (NAV). (While the SEC declined to set a materiality threshold for NAV errors, it noted that relying on the industry standard of $0.01 a share or 0.5% of NAV would not be unreasonable.) The valuation designee must make follow-on reports to such initial notification as the board may determine is appropriate. The release also notes that in cases where a valuation designee cannot determine the materiality of a valuation matter within 20 days of awareness, it must then notify the board of its ongoing evaluation within five business days of the matter awareness. (The prompt reports may be made to the full board or a designated committee of such composed of a majority of noninterested directors.)
Readily Available Market Quotations
Under the 1940 Act, if a market quotation is readily available for a portfolio security, it must be valued at market value. If not, the portfolio must be fair-valued as determined in good faith by the fund board or, under the new rule, the valuation designee. The new rule adopts a definition that a market quotation is deemed “readily available” with respect to a security only 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.” Prior to the new rule, “readily available” was not defined within the 1940 Act. Although there were past SEC positions addressing the matter, the new rule provides more concrete guidance on when exactly a market quotation is readily available.
Rescission of Prior Guidance
In connection with the adoption of the final rule, the SEC is rescinding ASR 113 and ASR 118 in their entirety, as the guidance within has been superseded or made redundant by the new rule. In addition, certain other SEC guidance and staff letters addressing a board's determination of fair value will be withdrawn or rescinded in connection with the rule adoption.
Effective Date
The final rule will become effective 60 days after publication in the Federal Register. However, the SEC is adopting an 18-month transition period beginning from the effective date of the rules to ensure sufficient time to prepare for compliance. A fund may voluntarily comply with the new rules in advance of the compliance date, once they become effective. (A fund that elects to do so may only rely on the new rules and not also consider other SEC guidance that will be withdrawn or rescinded.)
The full text of the SEC release may be found here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
