Category: Alerts

SEC Proposes Updates for Fund Valuation Practices

For the first time since Apollo 13 safely splashed down, the SEC seeks to comprehensively update fund valuation practices under the Investment Company Act of 1940 (the “Act”).1 On April 21, 2020, the Commission proposed a new rule 2a-5 under the Act (“Proposed Rule 2a-5”). Prior to the Proposed Rule 2a-52 the SEC has dealt with valuation issues in an ad hoc fashion.3 While the SEC has recently expressed its concern on valuation issues,4 Proposed Rule 2a-5 makes it clear that valuation is a priority. SEC Chairman Jay Clayton has stated that “[t]he way a fund values its investments is critical to our Main Street investors . . . It affects the fees they pay, the returns they receive, and the value of the fund shares they hold. Today’s proposal would improve fund valuation practices, including oversight, thereby protecting investors and improving market efficiency, integrity and fairness.”5

Who Does This Affect?

Proposed Rule 2a-5 which explicitly rescinds prior SEC valuation guidance6, would “apply to all registered investment companies and Business Development Companies, regardless of their classification or sub-classification (e.g., open-end funds and closed-end funds, including BDCs), or their investment objectives or strategies (e.g., equity or fixed income; actively managed or tracking an index).”7

What Does The Rule Change Mean?

Proposed Rule 2a-5 establishes the requirements for good faith determinations of the fair value of a fund’s investments for securities and assets without readily available market quotations.8 A market quotation is considered 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.”9

Not surprisingly, Proposed Rule 2a-5 details the board’s obligations in good faith determinations of a fund’s investments. It also describes the steps the board must take to satisfy these obligations including: (i) assessment and management of material risks associated with fair value determinations; (ii) selection, application, and testing of fair value methodologies; (iii) overseeing and evaluating pricing services, if applicable; (iv) adoption and implementation of policies and procedures; and, (v) maintenance of certain records.10

Notably, Proposed Rule 2a-5, while emphasizing that it ultimately is the board’s responsibility, permits the board to delegate valuation questions to the fund’s investment advisor.11 Boards oversight obligations must be robustly discharge as boards “should approach their oversight of fair value determinations assigned to an investment adviser of the fund with a skeptical and objective view that takes account of the fund’s particular valuation risks, including with respect to conflicts, appropriateness of the fair value determination process, and the skill and resources devoted to it.”12 Further, the board must implement: (i) specific reporting by the adviser in a periodic and prompt manner; (ii) clear delineation of responsibilities and reasonable segregation of duties among the adviser’s personnel; and, (iii) additional recordkeeping.13

It is impressive that the SEC is capable of dropping a 141 page proposal during these difficult times. It is also a clear indication that the Commission is taking valuation issues seriously. While the final form of the rule has not been finalized (comment period is open until July 21, 2020) we anticipate that it will not significantly deviate from Proposed Rule 2a-5. As such, firms should be prepared to review and update the sections of their compliance manuals that address valuation and implement the review, record keeping, testing, and other requirements of the new rule.

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With over 275 years of cumulative financial services compliance expertise, we have managed over 100 regulatory examinations while serving as chief compliance officers. Alaric also regularly reports to and works with boards in our roles as CCO and compliance consultant on issues including valuation.

Alaric has extensive experience and capability consulting with boards to structure as well as implement new policies and procedures on valuation and other issues. Leveraging this experience, our team of former regulators, lawyers, and in-house chief compliance officers can help your firm keep your compliance program healthy.

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1 SEC Proposes to Modernize Framework for Fund Valuation Practices, SEC Press Release dated April 21, 2020 (“The Press Release”).
2 Good Faith Determinations of Fair Value, Release No. IC-33845; File No. S7-07-20 (the “Proposed Rule 2a-5″).
3 See, e.g., See, Division of Investment Management: December 1999 Letter to the ICI Regarding Valuation Issues, December 8, 1999.
4 See, e.g. Alaric Alert, “Do Not Neglect Your Compliance Health During the COVID-19 Pandemic”,
5 Press Release.
6 Id.
7 Proposed Rule 2a-5 at p. 16.
8 Id. at p. 57.
9 Id. at p. 57-58.
10 Id. at p. 17 et seq.
11 Id. at p. 15.
12 Id. at p. 34-35.
13 Id. at p. 31 et seq.

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