On Dec. 3, 2020, the SEC adopted new Rule 2a-5 (the “Rule”)1 under the Investment Company Act of 1940, as amended (the “1940 Act”). This Rule provides a framework for fund valuation practices and clarity on how a fund’s board can satisfy its statutory obligation to fair value portfolio securities where there are no readily available market quotations. In this article, we’ll provide an overview of the Rule and outline some of its various requirements.
Recognizing that most mutual fund boards do not play a day-to-day role in the pricing of fund investments, the Rule permits a fund’s board to designate certain parties to perform the fair value determinations, subject to board oversight and certain reporting and other requirements. Specifically, a board may designate a fund’s investment adviser or, if the fund is internally managed, an officer of the fund as its “valuation designee” to perform fair value determinations on behalf of the board.
The Rule also defines when market quotations are “readily available” for purposes of the 1940 Act, as existing Rule 2a-4 under the 1940 Act provides that securities for which market quotations are not readily available shall be valued “at fair value as determined in good faith by the board.” The Rule defines 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, provided that a quotation will not be readily available if it is not reliable.” However, it’s important to note that this definition does not include evaluated prices.
In addition, the Rule requires a board, or its valuation designee, to do the following:
- Assess and manage material risks associated with fair value determinations.
- Select, apply and test fair value methodologies utilized by the board and/or its valuation designee.
- Oversee and evaluate any pricing services utilized by the fund.
The Rule makes clear that board oversight in the fair valuation process must be active even if a board chooses to delegate portions of its responsibilities for determination of fair value in good faith to a designee. In conjunction with the adoption of the Rule, corresponding recordkeeping requirements for funds and their advisers for the maintenance of certain documents related to fair value determinations were also adopted and are discussed further below.
Fair value requirements of board or valuation designee
In order for a board or its valuation designee, as applicable, to determine fair value in good faith under the Rule, the following requirements must be addressed:
Periodically assess and manage material risks associated with the determination of fair valuation of fund investments. Risks to be considered include, but are not limited to, the following:
- The types of investments held or intended to be held by the fund.
- Potential market or sector shocks or dislocations and other types of disruptions that may affect a valuation designee’s or a third party’s ability to operate.
- The extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the valuation designee.
- The proportion of the fund’s investments that are fair valued as determined in good faith, and their contribution to the fund’s returns.
- Reliance on service providers that have more limited expertise in relevant asset classes; the use of fair value methodologies that rely on inputs from third-party service providers; and the extent to which third-party service providers rely on their own service providers.
- The risk that methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.
Establish and apply fair value methodologies
- Select and apply in a consistent manner an appropriate methodology(ies) for determining fair value. This requires a board or valuation designee to specify the key inputs and assumptions specific to each asset class or portfolio holding. Any change in methodology must be documented under the applicable recordkeeping requirements noted below.
- Periodically review the appropriateness and accuracy of the methodologies selected and make any necessary changes or adjustments.
- Monitor for circumstances that may necessitate the use of fair value.
Test fair value methodologies for appropriateness and accuracy
- Identify the testing methods to be used and the minimum frequency with which such testing methods are utilized. Note, the Rule does not specify particular testing methods or a specific minimum frequency for testing the methods that are utilized. However, the Rule does note that the board or valuation designee has a duty to investigate its methodology if there is a consistent discrepancy between fair valued prices and observed prices for a fund investment.
- For funds that use pricing services to assist the board or valuation designee in the determination of fair value, the Rule requires that a fund’s board or valuation designee establish a process for approving, monitoring and evaluating each pricing service provider, as well as establish a process for initiating price challenges as appropriate.
Fair value policies and procedures
- The Rule does not separately include a policies and procedures requirement. Instead, the adopting release for the Rule notes that Rule 38a-1 requires the adoption and implementation of written policies and procedures reasonably designed to prevent violations of fair value policies and procedures. As such, the creation of a new framework for fair value determinations under the Rule means each fund must now adopt and implement fair value policies and procedures that are reasonably designed to prevent violations of the Rule and Rule 31a-4 (discussed below in the Recordkeeping section).
Performance of fair value determinations
A board may make fair value determinations itself by carrying out the functions set forth above. Alternatively, as noted above, a board may designate fair value determinations to a valuation designee, subject to certain requirements discussed below. Notably, the Rule does not permit boards to designate the performance of fair value determinations to fund sub-advisers. However, the valuation designee may seek the assistance of sub-advisers as they see appropriate. Valuation designees are additionally encouraged to seek assistance from pricing services, fund administrators, accountants or counsel, as necessary.
- The adopting release for the Rule provides guidance on how boards could satisfy their oversight responsibilities with respect to fair value determinations by the valuation designee. The release suggests that boards should approach oversight with a skeptical and objective view that takes account of the fund’s particular valuation risks, including with respect to conflicts of interest, the appropriateness of the fair value determination process, and the skill and resources devoted to it.
- The Rule requires a valuation designee to report to the board, in writing, on at least a quarterly basis, on (1) 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 and (2) a summary or description of material fair value matters that occurred in the prior quarter.
- The Rule requires the valuation designee to provide an annual assessment, in writing, of the adequacy and effectiveness of the valuation designee’s process for determining fair value of the designated portfolio investments. This annual report must include (1) a summary of the results of the testing of fair value methodologies and (2) 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.
- The Rule requires prompt notification on the occurrence of matters that materially affect the fair value of investments whose fair value is determined by the valuation designee within a time period determined by the board, but in no event later than five business days after the valuation designee becomes aware of the material matter.
Specifications of functions
- The Rule requires the valuation designee to specify the titles of the persons responsible for determining the fair value of the designated investments, including by specifying the functions for which the persons identified are responsible.
Consistent with the adoption of the Rule, the SEC additionally announced the adoption of the recordkeeping requirements under proposed Rule 31a-4. Rule 31a-4 requires funds or their advisers to maintain appropriate documentation to support fair value determinations. In addition, Rule 31a-4 provides that, in cases where the board has designated the performance of fair value determinations to a valuation designee, the reports and other information provided to the board must include a specified list of the investments or investment types for which the valuation designee has been designated. These records will generally be required to be maintained for six years, the first two years in an easily accessible place.
Rule 31a-4 additionally requires funds or their advisers to maintain appropriate documentation to support fair value determinations. Lastly, the fund will be required to maintain these records unless the board has designated the performance of fair value determinations to the fund’s investment adviser. In that case, the investment adviser will maintain the records.
The SEC is adopting an 18-month transition period beginning from the effective date of the Rule to provide sufficient time for funds and valuation designees to prepare to come into compliance with the Rule. The Rule became effective on March 8, 2021 with a compliance date of Sept. 8, 2022.
U.S. Bank Global Fund Services is working to confirm that we have the appropriate tools in place to help clients understand and comply with the Rule. To that end, clients should consider the following next steps:
- Evaluate whether existing policies and procedures for fair valuing securities comply with the requirements of the Rule.
- To the extent a board currently designates fair valuation to a designee, consider whether the current form of reporting to the board would satisfy the Rule’s board reporting requirements.
- Determine controls to create appropriate segregation of responsibilities between (1) the valuation designee’s fair valuation determinations, and (2) the valuation input from portfolio management.
At U.S. Bank, we’re here to help you with implementing Rule 2a-5. Please contact us or reach out to your relationship manager if you have questions about this new regulatory framework. To learn more about our other products and solutions, visit usbank.com/globalfundservices.