U.S. Security and Exchange Commission’s New Fund Valuation Framework Rule

On December 3, 2020 the U.S. Securities and Exchange Commission (SEC) announced the adoption of a new rule focused on fund valuation practices. The rule is applicable to all registered investment companies, including mutual funds, business development companies (BDCs) and unit investment trusts (UITs). The new rule also gives insight into how the SEC is thinking about valuation governance and valuation best practice for private funds managed by registered investment advisers.

Existing SEC valuation rules date back to 1969 and 1970. With the release of the new rule, SEC Chairman Jay Clayton stated: “Today’s rule is designed to improve funds’ valuation practices, including by providing for effective board oversight, for the benefit and protection of fund investors.”

Determining Fair Value in Good Faith

Section 2(a)(41) of the 1940 Investment Company Act mandates that the board of a fund determine fair value in good faith. The nature and character of investments has changed substantially over the past 50 years since the SEC released Accounting Series Releases (ASR) 113 and 118 in 1969 and 1970. With the adoption of the new rule (2a-5) the Commission rescinded ASR 113 and 118. 

New rule 2a-5 outlines the requirements that must be followed to satisfy a board’s obligation to determine fair value in good faith as required by the Investment Company Act. A board must actively oversee the valuation process. The new rule allows the board to designate the investment adviser as the party to determine fair value. When designating the fair value determination to the investment advisor, a board has new oversight requirements. The board will need to ensure they receive expanded, prompt, periodic reporting and will need to specify the titles, functions, and independence of those responsible for fair value determinations. Further, they will need to oversee testing of the valuation process and may need to consider engaging qualified experienced valuation support to assist the board in their oversight responsibilities and/or to assist the valuation designee.

After the implementation period for the new rule, 18 months, boards who do not follow the new rule rigorously may be open to possible litigation and potential SEC enforcement action.

Alignment with Accounting Standards

The proposed rule is aligned with the requirements of Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Topic 820 Fair Value Measurement. Further, the proposed rule aligns with 2018 Public Company Accounting Oversight Board (PCAOB) audit standards which require greater scrutiny when fair value is determined using pricing services or broker quotes.

While proposed rule 2a-5 is congruent with current accounting standards, it does not mirror ASC Topic 820 exactly. This is because the rule needs to fit within the statutory framework of the 1940 Investment Company Act which differentiates between investments where a market quotation is readily available (i.e. a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date) and those investments where a market quotation is not readily available. Using FASB ASC Topic 820 concepts, an actively traded investment (Level I) is analogous to the 40 Act readily available market quotation. FASB ASC Topic 820 concepts that use Level II and Level III inputs are analogous to those investments needing to be “fair valued” under the 40 Act and Rule 2a-5.

Board Valuation Responsibilities

As previously indicated, the board of a registered investment company (and, by analogy, the manager of a private fund) is required to determine fair value in good faith. Rule 2a-5 requires that a board directly, or through delegation, undertake the following:

• Assess and manage valuation risks
• Establish and apply fair value methodologies
• Test fair value methodologies
• Evaluate pricing services

Further, the board needs to oversee the valuation designee and obtain quarterly, annual, and ad hoc written reports with respect to material changes, valuation methodologies, and errors if any.

In many ways the proposed rule codifies practices that have evolved over the past decades. Board’s retain responsibility for oversight but may use advisers and other engaged valuation expertise to assist in fulfilling their fair value oversight and testing obligations.

Conclusion

Modernization of the existing SEC good faith fair value determination rules has been long expected. At a time of increased public market volatility and economic uncertainty resulting from the COVID-19 pandemic, the need for experienced, independent and informed judgement when estimating fair value is required now more than ever. Alternative investment managers best serve their investors by providing relevant, reliable and transparent information. The SEC’s new rule provides boards with a framework for discharging their valuation oversight role and should further assist investors by improving overall fair value policies and processes and, thereby, providing investors with the decision useful fair value information they need. 

For More Information, Contact

David L. Larsen, Managing Director
[email protected]