Rule 2a-5 overview: Good faith determinations of fair value
Learn how a new framework under the 1940 Act permits a fund’s board to designate certain parties to perform fair value determinations – subject to board oversight, reporting and other requirements.
On Dec. 3, 2020, the SEC adopted new Rule 2a-5 (the “Rule”) 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:
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:
Establish and apply fair value methodologies
Test fair value methodologies for appropriateness and accuracy
Fair value policies and procedures
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.
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:
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.