On December 3, the SEC adopted Rule 2a-5 under the Investment Company Act of 1940, as amended. Under Rule 2a-5, determining fair value in good faith with respect to what a fund will require: (1) the periodic assessment and management of material risks associated with the determination of the fair value of the fund’s investments, including material conflicts of interest; (2) the establishment and application of fair value methodologies and the periodic review of the selected methodologies; (3) the testing of the appropriateness and accuracy of the fair value methodologies selected; and (4) the oversight and evaluation of pricing services, when used.
Under the Rule, a fund board may choose to determine fair value by applying the functions and elements set forth above, or it may choose to designate a “valuation designee” to perform such responsibilities, subject to board oversight as outlined below. If the board designates the performance of fair value determinations to a valuation designee of the adviser, the designee will be required to specify the titles of the individuals responsible for determining the fair value of the designated investments, including specifying the functions for which each is responsible.
When using a valuation designee, board oversight will include:
- Quarterly Reporting would include any reports or materials requested by the board related to the fair value of designated investments or the valuation designee’s process for fair valuing fund investments, as well as a summary or description of material fair value matters that occurred in the prior quarter, including material changes to the valuation risks, methodologies, and process for selecting and overseeing pricing services during the quarter.
- Annual Reporting would include an assessment of the adequacy and effectiveness of the valuation designee’s process for determining the fair value of the designated portfolio of investments that includes, at a minimum, a summary of the results of the testing of fair value methodologies required and an assessment of the adequacy of resources allocated to the process for determining the fair value of designated investments, including any material changes to the roles or functions of the persons responsible for determining fair value.
- More Immediate Reporting involves prompt board notification, and board reporting would be required within five business days for matters that materially affect the fair value of the designated portfolio of investments. Material matters may include a significant deficiency or material weakness in the design or effectiveness of the valuation designee’s fair value determination process or of material errors in the calculation of net asset value.
The Rule defines the term “readily available market quotation.” With respect to this definition, the SEC stated that some securities may no longer be eligible for cross trades under Rule 17a-7. The adopting release acknowledges that some funds enter into cross trades in reliance on certain SEC no-action letters. It states that the SEC is currently in the process of reviewing these no-action letters to determine whether these letters should be withdrawn.
In connection with the adoption of Rule 2a-5, the SEC is rescinding previously issued guidance on the role of the board in determining fair value and the accounting and auditing of fund investments.
Rule 2a-5 will become effective March 8, 2021, and will have a compliance date 18 months following the effective date.
The SEC’s final Rule is available at https://www.sec.gov/rules/final/2020/ic-34128.pdf.
To read the entire article, please go to https://www.troutman.com/insights/sec-adopts-modernized-framework-for-fund-valuation-practices.html.
John Falco is a partner at Troutman Pepper specializing in corporate governance, legal administration and registration of investment companies under the Investment Company Act of 1940.
John Ford is a partner at Troutman Pepper where he focuses his practice on investment company and investment adviser regulatory issues, and related issues affecting the investment management activities of financial institutions.
Terrance James Reilly is counsel at Troutman Pepper where he provides practical advice on the day-to-day management of mutual funds and other investment vehicles
Kyle Whiteman is an associate at Troutman Pepper where he advises registered investment funds and investment advisers on transactional and regulatory matters.