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(Article from Registered Funds Alert, May 2020)

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On April 21, 2020, the Securities and Exchange Commission published a long-awaited and highly anticipated rule proposal that, if adopted, would clarify valuation practices and the role of the board of directors in fair valuations of the investments held by a registered investment company or business development company (a “Regulated Fund”). The text of the new proposed rule—Rule 2a-5 under the Investment Company Act of 1940 (the “1940 Act”)—is summarized below. Comments to the proposal are due July 21, 2020.

Our Initial Views of the Proposal

The proposal appears to address quite a few concerns that have been raised by the industry regarding uncertainties with respect to valuation oversight. The Regulated Fund industry has long sought clarification on several matters related to valuation, and in particular the appropriate role of the board in the fair valuation process. Indeed, several prior Directors of the SEC’s Division of Investment Management have promised such clarification, especially in light of high-profile SEC enforcement actions regarding valuation that have, in some instances, involved findings against independent board members.

In general, we believe boards of Registered Funds will welcome the proposal. It reflects the SEC’s acknowledgement of the practical reality of the roles of the adviser and board in setting valuations, as well as an appreciation by the SEC that the adviser may ultimately be better positioned to make valuation determinations than the board.

We note in particular that the proposal calls for a formal new rule, as compared to SEC guidance. A rule should provide comfort to boards that their decision to delegate valuation responsibilities to an adviser (within the conditions established under a final rule) will present less potential for second-guessing than if the SEC only issued guidance, which inherently is less specific.

Notwithstanding the many positive attributes of the SEC’s proposal, we anticipate that boards, advisers and other interested parties will wish to comment on the proposal in an effort to enhance the final product. In particular, the proposed rule’s provisions regarding when market quotations are not “readily available” for purposes of valuations require close attention (see summary below).

We will be analyzing the proposal in depth and stand ready to assist in assessing topics that may be appropriate for comment.

Background and Overview of the Proposal

Section 2(a)(41)[1] defines the term “value” as it is used throughout the 1940 Act and requires that a Regulated Fund value its portfolio investments using the market value of its portfolio securities when market quotations for those securities are “readily available.” When a market quotation for a portfolio security is not readily available, the Regulated Fund must use the fair value of that security, as determined in good faith by the Regulated Fund’s board.

Proposed Rule 2a-5, if adopted as proposed, would impose specific required functions for determining fair value in good faith in accordance with the mandate of Section 2(a)(41). The proposed rule would also allow a Regulated Fund’s board to delegate the determination of an investment’s fair value to the Regulated Fund’s adviser, sub-adviser, or some combination thereof, while the board would retain only certain oversight responsibilities.

Below, we summarize key components of the proposed rule.

The Board May Delegate Fair Value Determinations to One or More Investment Advisers

• Proposed Rule 2a-5 would expressly permit a Regulated Fund’s board of directors to delegate the fair value determination relating to any or all investments to the Regulated Fund’s primary investment adviser, one or more sub-adviser, or any combination thereof. This would remove the significant uncertainty that exists today about the extent to which a board may delegate fair value determinations to an adviser. Because the 1940 Act, by its terms, gives the power to determine valuation solely to the board, the extent to which an adviser or sub-adviser could make a fair value determination has always been in doubt, although in practice such entities routinely make such fair value determinations pursuant to board-adopted policies and procedures.
• For example, the proposal permits the board of a Regulated Fund with a primary adviser and one or more sub-advisers to delegate the determination of fair value for all the fund’s investments to the primary adviser. In the alternative, the board could delegate that responsibility to each sub-adviser for the portion of the Regulated Fund’s portfolio that the sub-adviser manages.
• If the board of a Regulated Fund opts to delegate to an adviser, the adviser would become the party required to carry out the required functions described in proposed Rule 2a-5 (and summarized below). In addition to those required functions, the following requirements are imposed in the case of delegation to an adviser:
  • The board must continue to oversee valuation processes.

    • Proposed Rule 2a-5 does not specify precisely what a Regulated Fund’s board must do to satisfy this requirement. Consistent with its fiduciary duties and other obligations under the 1940 Act, we expect that it will likely seek to identify potential conflicts of interest, monitor such conflicts, and take steps necessary to ensure the appropriateness of the adviser’s fair value processes.

  • The adviser must report to the board.

    • Proposed Rule 2a-5 requires that the adviser, at least quarterly, provide the board a written assessment of the adequacy and effectiveness of the adviser’s process for determining the fair value of the assigned portfolio of investments.

    • The proposed rule also requires that the adviser promptly report to the board in writing on matters associated with the adviser’s valuation process that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments, including material changes in the Regulated Fund’s valuation risks.

    • The amount and timing of reporting prescribed by proposed Rule 2a-5 will likely be a focus of many comments. The prompt notification requirement, which requires written notification to the board within three business days of certain changes or events, in particular, seems likely to be controversial.

  • The adviser must clearly assign duties among its personnel.

    • If the board assigns the fair value determination requirements for one or more investments to an adviser, the proposed rule requires the adviser to specify to the board 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.

  • The adviser must keep additional records relevant to the delegation.

    • Under the proposed rule, in addition to the records that would need to be kept as part of a good faith determination of fair value generally, an adviser must also keep records related to the fair value determinations assigned to the adviser for a period of at least five years after the end of the fiscal year in which those records were provided to the board.

Required Functions for Determining Fair Value in Good Faith

• Proposed Rule 2a-5 requires the performance of certain functions to comply with the mandate of determining fair value in good faith. These functions must be performed by either the board, or if the board has elected to delegate, the Regulated Fund’s adviser or advisers. These functions include:
  • Periodically assessing and managing material risks associated with fair value determinations, including material conflicts of interest.

    • Other than material conflicts of interest, the proposed rule does not identify the specific valuation risks that must be assessed under this requirement. Each Regulated Fund’s risks would depend on the facts and circumstances of its particular investments.

    • The proposed rule also does not include a specific frequency for the required periodic re-assessment of a Regulated Fund’s valuation risks. Each Regulated Fund’s board or adviser would be responsible for determining the appropriate interval.

  • Selecting, applying and testing fair value methodologies, including specifying the key inputs and assumptions specific to each asset class and which methodologies should apply to new types of investments.

    • The proposed rule does not specify the tests to be performed and the frequency with which such tests should be performed. Each Regulated Fund’s board or adviser would be responsible for determining the appropriate tests and testing intervals.

  • Overseeing and evaluating any pricing services used, including establishing criteria for initiating price challenges.

    • The rule proposal includes criteria that the board or adviser should consider when evaluating a pricing service, including such factors as qualifications, experience and history of the pricing service; the valuation methods or techniques, inputs and assumptions; and the pricing service’s potential conflicts of interest.

    • This element of the rule proposal has the potential to change current practice and, therefore, may draw pushback. Currently, as is acknowledged by the proposing release, many Regulated Funds rely on the expertise and proprietary know-how of pricing services when determining fair value of investments. As with hiring any service provider, Regulated Funds currently perform diligence to ensure they are hiring competent third parties. The proposed rule, however, appears to require a level of diligence that goes beyond typical service provider diligence, and contemplates an in-depth examination of the techniques, formulas and inputs pricing services use. If adopted as proposed, this element could call for much more extensive and frequent investigation of pricing services than is common practice today.

  • Adopting and implementing written policies and procedures addressing fair value determinations and instituting certain recordkeeping requirements.

    • Under the proposed rule, where the board determines the fair value of investments, the board-approved fair value policies and procedures would be adopted and implemented by the fund. Where the board assigns fair value determinations, the fair value policies and procedures would be adopted and implemented by the adviser, subject to board approval and oversight under Rule 38a-1.

    • While existing Regulated Funds and their advisers will likely already have policies and procedures in place that address fair value determinations, they would need to update their existing policies and procedures to account for the specific requirements of proposed Rule 2a-5.

    • Proposed Rule 2a-5 also requires that all Regulated Funds retain appropriate documentation to support fair value determinations, including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations, as well as any necessary or appropriate adjustments in methodologies, for at least five years from the time the determination was made.

Readily Available Market Quotations

• A Regulated Fund’s investments must be fair valued where market quotations are not “readily available.” Proposed Rule 2a-5 treats a market quotation as “readily available” only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the Regulated Fund can access at the measurement date.
• The proposal also provides that a market quotation is not readily available if such quotation is unreliable. A quote would be considered unreliable under proposed Rule 2a-5(c) in circumstances where it would require adjustment or require consideration of additional inputs in determining the value of the security under the generally accepted accounting principles of the United States.
• The proposal here has the potential to change the standard for assessing whether a security does not have a readily available quotation and therefore must be fair valued. As such, this aspect of the proposal requires close attention and likely warrants commenters’ feedback.

Rescission of Prior Commission Releases and Review of Relevant Staff Guidance

• The SEC also proposes to rescind a number of staff letters and other SEC and staff guidance addressing fund valuation matters covered by the proposal. The existing guidance, some of which is problematic today, would no longer be applicable if the SEC adopts Rule 2a-5.
• The SEC proposes to rescind two SEC releases if Rule 2a-5 is adopted: Accounting Series Release 113 and Accounting Series Release 118, which provide Commission guidance on, among other things, how to determine fair value for restricted securities.

[1] Unless otherwise indicated, all section and rule references herein are to sections of, and rules under, the 1940 Act.