On April 21, 2020, the Securities and Exchange Commission (“SEC”) proposed new Rule 2a-5 under the Investment Company Act of 1940 (the “1940 Act”) to “modernize” the framework for fund valuation practices applicable to mutual funds, business development companies and other “registered investment companies” under the 1940 Act (each, a “fund”). This framework has not been fully addressed by the SEC since a pair of releases issued in 1969 and 1970. As the SEC notes, market practice has evolved since then – third-party pricing services are often used by funds to provide valuation information and the fund’s investment adviser has taken on a more prominent role. The proposal recognizes these new market practices and intends to “improve valuation practices, including oversight, thereby protecting investors and improving market efficiency, integrity and fairness.”

The 1940 Act defines “fair value” as valuations “determined in good faith by the board of directors.” Under the new proposed Rule 2a-5, requirements would be implemented for determining the fair value of a fund’s investments in good faith and would permit a fund’s board to assign this determination to the fund’s investment adviser, subject to certain conditions. Written policies and procedures addressing fair value would be mandated along with maintenance of certain records. To determine fair value in good faith, proposed Rule 2a-5 would require the performance of certain functions, including, for example:

  • Periodically assessing and managing material risks associated with fair value determinations, including material conflicts of interest;
  • Selecting, applying and testing fair value methodologies; and
  • Overseeing and evaluating any pricing services used.

Under the 1940 Act, the fund’s board of directors is responsible for determining in good faith the fair value of securities and assets without readily available market quotations. Proposed Rule 2a-5 would permit the board to assign this determination to the fund’s investment adviser, provided the following additional requirements would apply:

  • Board oversight of the adviser: the adviser must report to the board with respect to matters related to the adviser’s fair value determination process and the board must periodically review such process and the resources and expertise of the adviser;
  • Periodic and prompt reporting to the board: the adviser must provide the board with a written assessment of the adequacy and effectiveness of the adviser’s process, at least quarterly. Such report would include a summary of material valuation risks, material changes to or material deviations from methodologies, testing results, pricing vendor services and any other material requested by the board. The adviser also must promptly report in writing, within three business days of becoming aware of the matter, any matter that would materially affect the fair value of the assigned portfolio of investments;
  • Clear specification of responsibilities and reasonable segregation of duties among the adviser’s personnel; and
  • Keeping additional records relevant to the assignment to the adviser.

Where market quotations are not “readily available” fund investments must be given a fair value. Neither the 1940 Act nor the rules currently define what “readily available” means. Under the proposed rule, a market quotation is 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” and such quotation is reliable. The SEC noted where a quote requires adjustment under U.S. GAAP or where U.S. GAAP would require additional inputs to determine the value of a security, such quote would be considered unreliable. Further, “evaluated prices”, “indications of interest” and “accommodation quotes” are not per se “readily available” market quotations.

The proposal would also rescind certain staff letters, guidance and prior SEC releases upon adoption of the rule.

The public comment period for the proposal will remain open until July 21, 2020.