# Good Faith Determinations of Fair Value

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-08854

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** May 13, 2020
- **Citation:** 85 FR 28734

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210 and 270
[Release No. IC-33845; File No. S7-07-20]
RIN 3235-AM71
Good Faith Determinations of Fair Value

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is proposing a new rule (“rule 2a-5”) under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”) that would address valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company (a “fund”). The proposed rule would provide requirements for determining fair value in good faith with respect to a fund for purposes of section 2(a)(41) of the Act. This determination would involve assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records. The proposed rule would permit a fund's board of directors to assign the fair value determination to an investment adviser of the fund, who would then carry out these functions for some or all of the fund's investments. This assignment would be subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability effectively to oversee the adviser's fair value determinations. The proposed rule would include a specific provision related to the determination of the fair value of investments held by unit investment trusts, which do not have boards of directors. The proposed rule would also define when market quotations are readily available under section 2(a)(41) of the Act. If rule 2a-5 is adopted, the Commission would rescind previously issued guidance on the role of the board of directors in determining fair value and the accounting and auditing of fund investments.

DATES:

Comments should be submitted on or before July 21, 2020.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (
http://www.sec.gov/rules/interp.shtml
); or

• Send an email to
rule-comments@sec.gov.
Please include File Number S7-07-20 on the subject line.

Paper Comments

• Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-07-20. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website (
http://www.sec.gov/rules/interp.shtml
). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make publicly available.

Studies, memoranda or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at
www.sec.gov
to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Joel Cavanaugh, Senior Counsel; Bradley Gude, Senior Counsel; Thoreau A. Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management; Kieran G. Brown, Senior Counsel, or David J. Marcinkus, Branch Chief, at (202) 551-6825 or
IMOCC@sec.gov,
Chief Counsel's Office, Division of Investment Management; Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-8549. Regarding accounting and auditing matters: Jenson Wayne or Alexis Cunningham, Assistant Chief Accountants, or Jacob Sandoval, Branch Chief, at (202) 551-6918 or
IM-CAO@sec.gov,
Chief Accountant's Office, Division of Investment Management, Securities and Exchange Commission; or Jamie Davis or Thomas Collens, Professional Accounting Fellows, at (202) 551-5300 or
OCA@sec.gov,
Office of the Chief Accountant, Securities and Exchange Commission.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment 17 CFR 270.2a-5 (new rule 2a-5) under the Investment Company Act.

Table of Contents

I. Introduction

II. Discussion

A. Fair Value as Determined in Good Faith Under Section 2(a)(41) of the Act

1. Valuation Risks

2. Fair Value Methodologies

3. Testing of Fair Value Methodologies

4. Pricing Services

5. Fair Value Policies and Procedures

6. Recordkeeping

B. Performance of Fair Value Determinations

1. Board Oversight

2. Board Reporting

3. Specification of Functions

4. Records of Assignment

C. Readily Available Market Quotations

D. Rescission of Prior Commission Releases

E. Existing Staff No-Action Letters, Other Staff Guidance, and Proposed Transition Period

III. Economic Analysis

A. Introduction

B. Economic Baseline

1. Current regulatory framework

2. Current practices

3. Affected parties

C. Benefits and Costs and Effects on Efficiency, Competition, and Capital Formation of Proposed Rule

1. General Economic Considerations

2. Benefits

3. Costs

4. Effects on Efficiency, Competition, and Capital Formation

D. Reasonable Alternatives

1. More Principles-Based Approach

2. Assignment of Responsibilities to Service Providers Other Than Investment Advisers

3. Not Permit Boards To Assign Fair Value Determinations to an Investment Adviser

E. Request for Comment

IV. Paperwork Reduction Act Analysis

A. Introduction

B. Policies and Procedures

C. Board Reporting

D. Recordkeeping

E. Proposed Rule 2a-5 Total Estimated Burden

F. Request for Comment

V. Initial Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Proposed Actions

B. Legal Basis

C. Small Entities Subject to Proposed Rules

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Policies and Procedures

2. Recordkeeping

3. Board Reporting

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

G. Request for Comment

VI. Consideration of Impact on the Economy

VII. Statutory Authority

I. Introduction

The Investment Company Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations for those securities are “readily available,” and, when a market quotation for a portfolio security is not readily available, by using the fair value of that security, as determined in good faith by the fund's board.
1

The aggregate value of a fund's investments is the primary determinant of the fund's net asset value (“NAV”), which for many funds determines the price at which their shares are offered and redeemed (or repurchased).
2

Accordingly, proper valuation, among other things, promotes the purchase and sale of fund shares at fair prices, and helps to avoid dilution of shareholder interests.
3

Valuation also affects the accuracy of funds' asset-based and performance-based fee calculations;
4

disclosures of fund fees, performance, NAV, and portfolio holdings;
5

and compliance with investment policies and limitations.
6

As a result, improper valuation can cause investors to pay fees that are too high or to base their investment decisions on inaccurate information.
7

1
Section 2(a)(41) of the Investment Company Act.
See also
Investment Company Act rule 2a-4.

2
The Investment Company Act requires registered investment companies that issue redeemable securities to sell and redeem their shares at prices based on the current net asset value of those shares.
See
section 22(c) of the Investment Company Act and rule 22c-1(a) thereunder. Rule 2a-4 defines the term “current net asset value” of a redeemable security issued by a registered investment company and provides, similar to section 2(a)(41)(B), that “[p]ortfolio securities with respect to which market quotations are readily available shall be valued at current market value, and other securities and assets shall be valued at fair value as determined in good faith by the board of directors of the registered company.” Rule 22c-1(a) requires open-end funds to sell, redeem, or purchase shares at a price based on their current NAV next computed following receipt of an order.

Although closed-end funds are not subject to rules 2a-4 and 22c-1 under the Investment Company Act, section 23(b) limits the ability of closed-end funds to sell their common stock at a price below current NAV. Section 23(c) of the Investment Company Act provides for the repurchases of closed-end fund shares. The shares of closed-end funds (including business development companies (“BDCs”)) that are listed on an exchange often trade at a premium or discount to NAV.
See
Item 1.1(i) of Form N-2 (requiring closed-end funds whose securities have no history of public trading to include “a statement describing the tendency of closed-end fund shares to trade frequently at a discount from net asset value”).

3

See
Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016) (“Liquidity Risk Management Release”) (adopting rule 22e-4 under the Investment Company Act and noting “the risk of shareholder dilution associated with improper fund pricing”).

If fund shares are overpriced, selling shareholders will receive too much for their shares, and purchasing shareholders will pay too much for their shares. On the other hand, if fund shares are underpriced, selling shareholders will receive too little for their shares, and purchasing shareholders will pay too little for their shares.
See generally
Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 136-38 (1940) (discussing the effect of dilution on fund shareholders).

4

See
section 205 of the Investment Advisers Act of 1940 (“Advisers Act”) (permitting a fund's adviser to receive compensation based upon the total value of the fund and permitting certain specified types of performance fee arrangements with funds).

5

See, e.g.,
Item 3 of Form N-1A (requiring annual fund operating expenses to be disclosed in the fund's prospectus as a percentage of the value of a shareholder's investment); Item 4(b)(2) of Form N-1A (requiring certain disclosures about fund performance in fund prospectuses); Item 4.1 and Instruction 4.b. to Item 24 of Form N-2 (requiring disclosure of the fund's NAV in its prospectus and annual report); Item 6 of Form N-CSR and § 210.12-12 of Regulation S-X (requiring a schedule of the fund's investments, including the value of the investment, in the fund's annual report).

6

See
Rule 22e-4(b)(1)(iv) (generally prohibiting an open-end fund from acquiring an illiquid investment if such investment would cause more than 15% of such fund's net assets to be invested in illiquid investments).
See also
Liquidity Risk Management Release,
supra
footnote 3; Instruction 4 to Item 9(b)(1) of Form N-1A (requiring a fund to disclose any policy to invest more than 25% of its net assets in a particular industry or group of industries).

7
Fund advisers may have an incentive to overvalue fund assets, for example, to increase fees, but also in some cases may have incentives to undervalue fund assets, for example to smooth reported returns or comply with investment policies and restrictions.
See
In re Piper Capital Management, et al., Investment Company Act Release No. 26167 (Aug. 26, 2003) (Commission opinion) (“Piper”) (“the record shows that Respondents determined to smooth or ratchet down gradually the Fund's NAV over a period of days. It appears that Respondents sought to prevent an abrupt drop in the Fund's NAV as a result of updating the stale prices.”).
See also
Gjergi Cici, et al., Missing the Marks? Dispersion in Corporate Bond Valuations Across Mutual Funds, 101 J. Fin. Econ. 206 (2011) (observing evidence of price smoothing behavior in mutual funds and expressing concern that such smoothing may result in sub-optimal investment decisions) (“Cici et al. 2011”).

For these reasons, a number of the substantive requirements of the Investment Company Act relate to investment company valuation.
8

Moreover, the federal securities laws impose liability on funds, fund boards, and advisers for improperly valuing fund investments and for making material misstatements regarding a fund's valuation procedures.
9

Properly valuing a fund's investments also is a critical component of the accounting and financial reporting for investment companies.
10

Section 2(a)(41)(B) defines “value” for purposes of many of the requirements of the Investment Company Act as: (i) With respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors.
11

8

See infra
footnote 11.

9

See, e.g.,
15 U.S.C. 77
l
(a)(2); 15 U.S.C. 77k; 15 U.S.C. 78j(b); 15 U.S.C. 80a-33(b); 17 CFR 240.10b-5; 17 CFR 270.22c-1(a); 17 CFR 210.4-01(a)(1); 17 CFR 275.206(4)-8.

Section 206(1) of the Advisers Act makes it unlawful for an investment adviser to employ any device, scheme or artifice to defraud any client or prospective client. Section 206(2) of the Advisers Act makes it unlawful for an investment adviser to engage in any transaction, practice or course of business that operates as a fraud or deceit upon any client or prospective client. The Commission has brought enforcement actions under sections 206(1) and/or 206(2) of the Advisers Act against advisers for material misstatements or omissions to a fund's board (such as the failure to disclose that the adviser is not complying with the fund's stated valuation procedures) or willfully or recklessly aiding and abetting the misvaluing of fund investments.
See, e.g.,
In re Morgan Asset Management, et al., Investment Company Act Release No. 29704 (June 22, 2011) (settlement) (“In re Morgan Asset Management”).

10
Rule 6-02(b) of Regulation S-X defines the term “value” to have the same meaning as in section 2(a)(41)(B) of the Investment Company Act.

11
Section 2(a)(41) of the Investment Company Act defines “value” with respect to the assets of registered investment companies. Section 59 of the Investment Company Act makes section 2(a)(41) applicable to BDCs. Section 2(a)(41)(A) provides the definition of “value” under the Investment Company Act for purposes of whether an issuer is an investment company under section 3, is a “diversified company” or a “non-diversified company” under section 5, or exceeds certain investment limitations under section 12. Section 28(b) of the Investment Company Act contains provisions for the valuation of the investments of face-amount certificate companies. Section 2(a)(41)(B) defines value for all other purposes under the Investment Company Act. Section 2(a)(41)(A)(iii) provides that investments acquired after the last preceding quarter shall be valued at the cost thereof. In certain circumstances, section 2(a)(41) permits directors to determine in good faith the value of securities issued by controlled companies even though market quotations are available for such securities.

The Commission last comprehensively addressed valuation under the Investment Company Act in a pair of releases issued in 1969 and 1970, Accounting Series Release 113 (“ASR 113”) and Accounting Series Release 118 (“ASR 118”).
12

ASR 113

addressed a number of federal securities law and accounting topics related to the purchase of restricted securities by funds, including how to determine fair value
13

for such securities. A year later, ASR 118 expressed the Commission's views on certain valuation matters, including accounting and auditing, as well as the role of the board in the determination of fair value.

12
Statement Regarding “Restricted Securities,” Accounting Series Release No. 113 (Oct. 21, 1969); Accounting for Investment Securities by Registered Investment Companies, Accounting Series Release No. 118 (Dec. 23, 1970). In 1982, the Commission codified ASR 113 and ASR 118 in the “Codification of Financial Reporting Policies” as section 404.04: “ `Restricted' Securities” and section 404.03:

“Accounting, Valuation and Disclosure of Investment Securities,” respectively.
See
Codification of Financial Reporting Policies, Investment Company Act Release No. 12376 (Apr. 15, 1982) (codifying certain existing Accounting Series Releases, including ASR 113 and ASR 118). ASR 113 and ASR 118 continue to be included in the list of interpretive releases relating to the Investment Company Act found in 17 CFR part 271 as Investment Company Act Release Nos. 5847 and 6295, respectively. We refer to the releases herein as ASR 113 and ASR 118.

13
We generally use the term “fair value” in this release as that term is used in the definition of “value” in the Investment Company Act, that is, the value of securities for which no readily available market quotations exist.
See
section 2(a)(41) of the Investment Company Act and
supra
footnote 11.

In contrast to the Investment Company Act, FASB Accounting Standard Codification Topic 820:
Fair Value Measurement
(“ASC Topic 820”) uses the term “fair value” to refer generally to the value of an asset or liability, regardless of whether that value is based on readily available market quotations or on other inputs. Accordingly, when we use the term fair value in the release we are using it to mean fair value as defined under the Investment Company Act, unless we specifically note that we mean fair value under ASC Topic 820, such as in the sections below that discuss proposed rescission of the accounting guidance.
See also infra
notes 30 and 141.

The Commission acknowledged in ASR 113 and ASR 118 that the board need not itself perform each of the specific tasks required to calculate fair value in order to satisfy its obligations under section 2(a)(41). However, under ASR 113 and ASR 118 the board chooses the methods used to arrive at fair value, and continuously reviews the appropriateness of such methods.
14

In addition, the Commission stated that boards should consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available.
15

Finally, the Commission stated that whenever technical assistance is requested from individuals who are not directors, the findings of such individuals must be carefully reviewed by the directors in order to satisfy themselves that the resulting valuations are fair.
16

14
ASR 118 at 19988 (“it is incumbent upon the Board of Directors . . . to determine the method of arriving at the fair value of each such security”).
See also
Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) (“2014 Money Market Fund Release”) at n.896 (citing ASR 118). In ASR 113, the Commission similarly stated:

“It is the responsibility of the board of directors to determine the fair value of each issue of restricted securities in good faith . . . . While the board may, consistent with this responsibility, determine the method of valuing each issue of restricted securities in the company's portfolio, it must continuously review the appropriateness of any method so determined.”

15
ASR 118 at 19988 (“it is incumbent upon the Board of Directors to satisfy themselves that all appropriate factors relevant to the fair value of securities for which market quotations are not readily available have been considered”).
See also
2014 Money Market Fund Release,
supra
footnote 14, at n.896 (citing ASR 118).

16
ASR 118.

Since ASR 113 and ASR 118 were issued, markets and fund investment practices have evolved considerably. Funds now invest in a greater variety of securities and other instruments, some of which did not exist in 1970 and may present different and more significant valuation challenges.
17

Furthermore, advances in communications and technology have greatly enhanced the availability and currency of pricing information.
18

Today there is a greater volume of data available that may bear on determinations of fair value, and new technologies have developed that facilitate enhanced price discovery and greater transparency.
19

Many funds also now engage third-party pricing services to provide pricing information, particularly for thinly traded or more complex assets.
20

17

See
Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers' Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 33704 (“Derivatives Release”) (Nov. 25, 2019) (noting the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds); Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) at 69 (noting that “[v]aluation of some derivatives may present special challenges for funds”).

The fund industry has grown tremendously in the intervening years. For example, in December 1969, open-end funds had net assets of over $53 billion.
See
H.R. Rep. No. 1382, 91st Cong., 2d Sess. 2 (1970). As of August 31, 2019, there were 12,040 open-end funds registered with the Commission with total net assets of nearly $28 trillion. (We estimate the number of registered investment companies and their net assets by reviewing all Forms N-CEN filed with the Commission between June 2018 and August 2019.) Moreover, as of June 2019, there were 99 BDCs with $63 billion in total net assets. (Estimates of the number of BDCs and their net assets are based on a staff analysis of Form 10-K and Form 10-Q filings as of June 30, 2019.) BDCs, which did not exist in 1970, must invest at least 70% of their assets in certain investments that may be difficult to value.
See
Section 55(a) of the Act.

18
For example, FINRA's TRACE introduced in 2002 is an over-the-counter real-time price dissemination service for the fixed income market.
See https://www.finra.org/sites/default/files/TRACE_Overview.pdf

19
For example, the Electronic Municipal Market Access (“EMMA”) website, available since 2009, “provides free public access to objective municipal market information and interactive tools for investors, municipal entities and others.”
See https://emma.msrb.org/#.

20
2014 Money Market Fund Release,
supra
footnote 14 (“many funds . . . use evaluated prices provided by third-party pricing services to assist them in determining the fair values of their portfolio securities”).

In addition, three significant regulatory developments since 1970 have fundamentally altered how boards, advisers, independent auditors (also referred to herein as “independent accountants”), and other market participants address valuation for various purposes under the federal securities laws.

The first such development was the enactment of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) and the adoption of rules mandated by the Sarbanes-Oxley Act.
21

In particular, the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (“PCAOB”). The PCAOB oversees the audits of companies that are subject to the federal securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.
22

The PCAOB also has the authority to establish or adopt, among other things, professional standards, including audit and quality controls standards, to be used by registered public accounting firms in the preparation and issuance of audit reports.
23

In addition, section 108 of the Sarbanes-Oxley Act established criteria necessary for the work product of an accounting standard-setting body to be recognized as “generally accepted” for purposes of the federal securities laws.

24

Rule 30a-3 under the Investment Company Act, which was adopted in part to implement certain requirements of the Sarbanes-Oxley Act, requires registered management investment companies to maintain disclosure controls and procedures and internal control over financial reporting.
25

21
Sarbanes-Oxley Act, Public Law 107-204, 116 Stat. 745.

22

See
Sarbanes-Oxley Act,
supra
footnote 21, at Title I Sec. 101(a).

PCAOB auditing standards apply to the preparation or issuance of “audit reports,” which are defined to include documents, reports, notices, or other records that, among other things, are prepared following an audit performed for purposes of compliance by an issuer, broker, or dealer with the requirements of the securities laws.
See
PCAOB rule 3200; PCAOB rule 1001(a)(vi).
See also
PCAOB rule 1001(i)(iii) (defining the term “issuer” to include issuers (as defined in Section 3 of the Securities Exchange Act of 1934 (the “Exchange Act”)), the securities of which are registered under Section 12 of the Exchange Act, or that are required to file reports under the Exchange Act or that file or have filed registration statements that have not yet become effective under the Securities Act of 1933 (the “Securities Act”), and that have not been withdrawn).

23

See
Sarbanes-Oxley Act,
supra
footnote 21, at Title I Sec. 101(c)(2).

24
The federal securities laws for this purpose are the Securities Act, the Exchange Act, the Sarbanes-Oxley Act, the Trust Indenture Act of 1939, the Investment Company Act, the Advisers Act, and the Securities Investor Protection Act of 1970, and the rules, regulations and Commission orders thereunder.
See
PCAOB rule 1001(s)(ii); section 3(a)(47) of the Exchange Act.

25
The Commission adopted rule 30a-3 and a number of other rules in order to implement certain certification requirements of the Sarbanes-Oxley Act,
supra
footnote 21, that are applicable to companies filing reports under section 13(a) or 15(d) of the Exchange Act, and to extend those requirements to all registered management investment companies other than small business investment companies registered on Form N-5.
See
Certification of Management Investment Company Shareholder Reports and Designation of Certified Shareholder Reports as Exchange Act Periodic Reporting Forms; Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act, Investment Company Act Release No. 25914 (Jan. 27, 2003) (adopting Investment Company Act rule 30a-3); Management's Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Investment Company Act Release No. 26068 (June 5, 2003) (amending rule 30a-3).
See also
Certification of Disclosure in Companies' Quarterly and Annual Reports, Investment Company Act Release No. 25722 (Aug. 30, 2002) (adopting Exchange Act rules 13a-15 and 15d-15 to require that certain Exchange Act filers have disclosure controls and procedures in order “to assist principal executive and financial officers in the discharge of their responsibilities in making the required certifications, as well as to discharge their responsibilities in providing accurate and complete information to security holders”).

Second was the adoption in 2003 of compliance rules under the Investment Company Act and the Advisers Act (together, the “Compliance Rules”).
26

The Compliance Rules were designed to enhance compliance with the federal securities laws by requiring funds and advisers to adopt and implement written compliance policies and procedures that are reasonably designed to prevent violation of the federal securities laws, to review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and to designate a chief compliance officer (“CCO”) to be responsible for administering them.
27

Of particular relevance, the Commission stated that rule 38a-1 requires a fund to adopt compliance policies and procedures with respect to fair value that require the fund to:

26
17 CFR 270.38a-1 and 17 CFR 275.206(4)-7.
See also
Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) (“Compliance Rules Adopting Release”).

27
Investment Company Act rule 38a-1 provides that the policies and procedures must be reasonably designed to prevent violations of the federal securities laws (as defined in the rule), and Advisers Act rule 206(4)-7 provides that the policies and procedures must be reasonably designed to prevent violations of the Advisers Act and the rules thereunder.

1. Monitor for circumstances that may necessitate the use of fair value;

2. establish criteria for determining when market quotations are no longer reliable for a particular portfolio security;

3. provide a methodology or methodologies by which the fund determines fair value; and

4. regularly review the appropriateness and accuracy of the methodology used to determine fair value, and make any necessary adjustments.
28

28
Compliance Rules Adopting Release,
supra
footnote 26, at section II.A.2.c.

Third was the issuance and codification by the Financial Accounting Standards Board (“FASB”) of ASC Topic 820 in 2006 and 2009.
29

ASC Topic 820 defines the term “fair value” for purposes of the accounting standards
30

and establishes a framework for the recognition, measurement, and disclosure of fair value under U.S. generally-accepted accounting principles (“U.S. GAAP”).
31

29
The FASB issued
Fair Value Measurements,
Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”), in September 2006, and codified it in 2009 as ASC Topic 820.

30

See supra
footnote 13 (describing the difference between what “fair value” means under the Investment Company Act and under ASC Topic 820).

31

Id.
Rule 4-01(a)(1) of Regulation S-X [17 CFR 210.4-01(a)(1)] states that “[f]inancial statements filed with the Commission which are not prepared in accordance with generally accepted accounting principles will be presumed to be misleading or inaccurate, despite footnote or other disclosures, unless the Commission has otherwise provided.”

Taken together, we believe these regulatory developments have significantly altered the framework in which funds, boards, fund investment advisers, other fund service providers such as pricing services, and auditors perform various functions relating to fair value determinations. We believe that today determining fair value often requires greater resources and expertise than when the Commission issued ASR 113 and ASR 118 roughly fifty years ago. In addition, we believe that regulatory changes during that period have altered the way that boards, fund investment advisers, other fund service providers, and auditors address valuation. Our views are also informed by significant outreach that the staff has conducted with funds, investment advisers, audit firms, trade groups, fund directors, and others, particularly over the past two years. As part of these discussions, many boards sought additional clarity on how they can effectively fulfill their fair value determination obligations while seeking the assistance of others. The staff understands that this is of particular focus in light of the increased complexity of many fund portfolios and the in-depth expertise required to accurately fair value such complex investments.

In recognition of these changes, we are proposing a new rule to reflect the increased role that subsequent accounting and auditing developments play in setting fund fair value practices, as well as the growing complexity of valuation and the interplay of the compliance rule in facilitating board oversight of funds. The proposed rule also acknowledges the important role that fund investment advisers now play and expertise they now provide in the fair value determination process given these and other developments.

II. Discussion

The proposed rule would provide requirements for determining fair value in good faith with respect to a fund for purposes of section 2(a)(41) of the Act and rule 2a-4 thereunder.
32

We believe that, in light of the developments discussed above, to determine the fair value of fund investments in good faith requires a certain minimum, consistent framework for fair value and standard of baseline practices across funds, which would be established by the proposed rule. The proposed rule would also permit a fund's board to assign fair value determinations to an investment adviser of the fund.
33

Permitting a fund's board to assign fair value determinations to an investment adviser is designed to recognize the developments discussed above, including the important role that fund investment advisers now play and expertise they now provide in the fair value determination process, given these developments. However, when a fund's board uses the services of a fund investment adviser as part of the fair value determination process, we believe it is particularly important to establish a framework for boards to effectively oversee the investment adviser through the proposed rule, in light of the adviser's conflicts of interest and given that, in these circumstances, the fund's board would satisfy its statutory obligation to determine fair value in good faith through the framework of the proposed rule, including this board oversight.

32
The rule would define “fund” as a registered investment company or a business development company. Proposed rule 2a-5(e)(1).

33
For purpose of the proposed rule, “board” means either the fund's entire board of directors or a designated committee of such board composed of a majority of directors who are not interested persons of the fund. Proposed rule 2a-5(e)(3).

Accordingly, under the proposed rule, fair value as determined in good faith would require assessing and managing

material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records.
34

These required functions generally reflect our understanding of current practices used by funds to fair value their investments and we discuss each in detail below. When a board assigns the determination of fair value to an adviser for some or all of the fund's investments under the proposed rule, in addition to board oversight, the rule would include certain reporting, recordkeeping, and other requirements designed to facilitate the board's oversight of the adviser's fair value determinations.
35

34
Proposed rule 2a-5(a).

35
Proposed rule 2a-5(b).

The proposed rule would apply to all registered investment companies and BDCs, regardless of their classification or sub-classification (
e.g.,
open-end funds and closed-end funds, including BDCs
36

), or their investment objectives or strategies (
e.g.,
equity or fixed income; actively managed or tracking an index).
37

In the case of a unit investment trust (“UIT”), because a UIT does not have a board of directors or investment adviser, a UIT's trustee would conduct fair value determinations under the proposed rule.
38

36
An open-end fund is a management investment company that offers for sale or has outstanding redeemable securities of which it is the issuer.
See
section 5(a)(1) of the Investment Company Act. A closed-end fund is a management investment company other than an open-end fund.
See
section 5(a)(2) of the Investment Company Act. Section 2(a)(48) of the Investment Company Act defines a “business development company” as any closed-end investment company that operates for the purpose of making investments in securities described in section 55(a)(1) through 55(a)(3) of the Investment Company Act and that makes available significant managerial assistance with respect to the issuers of such securities.

37

See
proposed rule 2a-5(e)(1) (defining “fund” to mean a registered investment company or business development company).

38
Proposed rule 2a-5(d). Section 4(2) of the Investment Company Act defines a UIT as an investment company that (1) is organized under a trust indenture or similar instrument, (2) does not have a board of directors, and (3) issues only redeemable securities, each of which represents an undivided interest in a unit of specified securities.
But see
Form N-7 for Registration of Unit Investment Trusts under the Securities Act of 1933 and the Investment Company Act of 1940, Investment Company Act Release No. 15612, Appendix B, Guide 2, [52 FR 8268, 8295-96 (Mar. 17, 1987)] (Staff Guidelines stating that the board's fair value role under section 2(a)(41) is to be performed by the UIT's trustee or the trustee's appointed person).
See infra
section II.D (rescission of staff guidance).

We are also proposing to rescind ASR 113 and 118, which provide guidance on, among other things, the role of the fund board in fair value determinations as well as guidance on certain accounting and auditing matters. In addition, the staff letters related to the board role in the fair value process would be withdrawn as discussed in section II.E below.
39

39
The staff's review will include, but will not necessarily be limited to, the letters identified in that section.

A. Fair Value as Determined in Good Faith Under Section 2(a)(41) of the Act

We discuss below each of the required functions set forth in proposed rule 2a-5(a) that must be performed to determine in good faith the fair value of the fund's investments.
40

40
These requirements would apply to a fund's board that is determining fair value or, if the board assigns any fair value determinations to an adviser as discussed below, to that adviser.

1. Valuation Risks

Proposed rule 2a-5 would provide that determining fair value in good faith requires periodically assessing any material risks associated with the determination of the fair value of the fund's investments, including material conflicts of interest, and managing those identified valuation risks.
41

We believe that assessing and managing identified valuation risks is an important element for determining fair value in good faith because ineffectively managed valuation risks can make it more likely that a board or an adviser may incorrectly value an investment.

41
Proposed rule 2a-5(a)(1). Valuation risk includes the risks associated with the process of determining whether an investment must be fair valued in the first place.

There are many potential sources of valuation risk. A non-exhaustive list of the types or sources of valuation risk includes:

• The types of investments held or intended to be held by the fund;

• potential market or sector shocks or dislocations;
42

42
Potential indicators of market or sector shocks or dislocations could include a significant change in short-term volatility or market liquidity, significant changes in trading volume, or a sudden increase in trading suspensions.

• the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the adviser;
43

43

See infra
footnotes 209-210 and accompanying text.

• 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 (so-called “fourth party” risks); and

• the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.

Other than material conflicts of interest, the proposed rule does not identify the specific valuation risks to be addressed under this requirement. Rather, we believe that specific valuation risks would depend on the facts and circumstances of a particular fund's investments. The proposed rule also does not include a specific frequency for the required periodic re-assessment of a fund's valuation risks, as we believe that different frequencies may be appropriate for different funds or risks. We believe that the periodic re-assessment of valuation risk generally should take into account changes in fund investments, significant changes in a fund's investment strategy or policies, market events, and other relevant factors.

We request comment on the proposal to require the assessment and management of the material risks associated with fair value determinations.

1. Is this requirement appropriate? Should we further define what risks would need to be considered or provide guidance on the types of valuation risks that a fund may face? Are there additional sources or types of valuation risk that we should address? If so, what sources?

2. Should we require a certain minimum frequency for re-assessing valuation risk (
e.g.,
annually or quarterly)? Should the rule specify types of market events or investment strategy changes that would require a re-assessment of valuation risk? If so, what events or changes should prompt such a review?

3. Should we provide any further guidance on how valuation risk should be managed?

2. Fair Value Methodologies

Proposed rule 2a-5 would provide that fair value as determined in good faith requires selecting and applying in a consistent manner an appropriate methodology or methodologies
44

for

determining (which includes calculating) the fair value of fund investments. This requirement would include specifying (1) the key inputs and assumptions specific to each asset class or portfolio holding, and (2) the methodologies that will apply to new types of investments in which the fund intends to invest.
45

The proposed rule also would require the selected methodologies to be periodically reviewed for appropriateness and accuracy, and to be adjusted if necessary. Selecting and applying a methodology consistently—and reviewing the methodology and adjusting it if necessary—are all important elements to determining fair value in good faith.
46

This is because an inappropriate methodology, or a methodology that is applied inconsistently, increases the likelihood that a fund's investments will be improperly valued.

44
ASC Topic 820 refers to valuation approaches and valuation techniques. In practice, many valuation techniques are referred to as
methods
(
e.g.,
discounted cash flow method). As a result, this release uses the terms “technique” and “method” interchangeably to refer to a specific way of determining fair value and likewise uses the

terms “methods” and “methodologies” interchangeably.

45
Proposed rule 2a-5(a)(2). Regarding the key inputs and assumptions specific to each asset class or portfolio holding, it would not be sufficient, for example, to simply state that private equity investments are valued using a discounted cash flow model, or that options are valued using a Black-Scholes model, without providing any additional detail on the specific qualitative and quantitative factors to be considered, the sources of the methodology's inputs and assumptions, and a description of how the calculation is to be performed (which may, but need not necessarily, take the form of a formula).

46
Different methodologies may be appropriate for different asset classes. Accordingly, this requirement would not require that a single methodology be applied in all cases, but instead that any methodologies selected be applied consistently to the asset classes for which they are relevant.

Currently, ASC Topic 820 refers to valuation approaches, including the market approach, income approach, and cost approach, as well as valuation techniques and methods as ways in which to measure fair value.
47

To be appropriate under the rule, and in accordance with current accounting standards, a methodology used for purposes of determining fair value must be consistent with ASC Topic 820, and thus derived from one of these approaches. We recognize, however, that there is no single methodology for determining the fair value of an investment because fair value depends on the facts and circumstance of each investment, including the relevant market and market participants.
48

47

See supra
footnote 44.

48

See
ASR 118 (“Methods which are in accord with this principle may, for example, be based on a multiple of earnings, or a discount from market of a similar freely traded security, or yield to maturity with respect to debt issues, or a combination of these and other methods.”). Consistent with the principles in ASC Topic 820, under the proposal, the methodologies selected should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.

Proposed rule 2a-5 also would require that the board or adviser consider the applicability of the selected fair value methodologies to types of fund investments that a fund does not currently hold but in which it intends to invest in the future.
49

This requirement is designed to facilitate the effective determination of the fair value of these new investments by the board or adviser. In addition, the proposed rule would require periodic reviews of the selected fair value methodologies for appropriateness and accuracy, and adjustments to the methodologies where necessary. For example, the results of back-testing or calibration (as discussed below) or a change in circumstances specific to an investment could necessitate adjustments to a fund's fair value methodologies.
50

As discussed above, while the proposed rule would require that the fair value methodologies be consistently applied to the asset classes for which they are relevant, there can be circumstances where it is appropriate to adjust methodologies if the adjustments would result in a measurement that is equally or more representative of fair value.
51

The proposed rule's requirement to apply fair value methodologies in a consistent manner would not preclude the board or adviser from changing the methodology for an investment in such circumstances.
52

49
Proposed rule 2a-5(a)(2)(i). For example, the board or adviser, as applicable, generally should address, prior to the fund's investing in a new type of investment, whether readily available market quotations will be used or if the investment may need to be fair valued on occasion or at all times. For certain types of investments, it should be clear that the asset will require a fair value at all times. For others, however, market quotations may sometimes be readily available and sometimes not, so that periodically a fair value will need to be determined. The board or adviser generally should seek to identify sources of price inputs before the fund invests in such asset classes, if possible, in addition to determining an appropriate fair value methodology, and generally should document these decisions.

50
Proposed rule 2a-5(a)(2)(ii). ASC Topic 820-10-35-25 provides a non-exhaustive list of events that may warrant a change or an adjustment to a valuation technique, including where (1) new markets develop, (2) new information becomes available, (3) information previously used is no longer available, (4) the valuation technique improves, and (5) market conditions change. Boards or advisers generally should seek to account for such occurrences and consider specifying alternative sources.

51

See
ASC Topic 820-10-35-25.

52
Records supporting any such methodology changes would be required to be maintained under the proposed recordkeeping provisions.
See
proposed Rule 2a-5(a)(6).

The proposed rule also would require the board or adviser to monitor for circumstances that may necessitate the use of fair value as determined in good faith.
53

The use of fair value is required when market quotations are not readily available. The rule would require the establishment of criteria for determining when market quotations no longer are reliable, and therefore are not readily available.
54

For example, if a fund invests in securities that trade in foreign markets, the board or adviser generally should identify and monitor for the kinds of significant events that, if they occurred after the market closes in the relevant jurisdiction but before the fund prices its shares, would materially affect the value of the security and therefore may suggest that market quotations are not reliable.
55

53
Proposed rule 2a-5(a)(2)(iii). As discussed below, we are also proposing to define when market quotations are readily available for purposes of section 2(a)(41).

54
Proposed rule 2a-5(a)(2)(iv).

55

See
ASC Topic 820-10-35-41C(b).

We continue to believe that for any particular investment there may be a range of appropriate values that could reasonably be considered to be fair value, and whether a specific value should be considered fair value will depend on the facts and circumstances of the particular investment. Accordingly, we expect that the methodologies used may reflect this range of potential fair values and result in unbiased determinations of fair value within the range.

We request comment on the proposed requirement to establish and apply the methodologies for determining and calculating fair value.

4. This requirement includes several specified elements, discussed above, relating to the fair value methodologies. Are these elements appropriate? Are there additional elements that commenters believe should be included under this requirement? Should we modify or remove any of the proposed elements? Should we require application of the methodologies in a reasonably consistent manner, or as consistently as possible under the circumstances?

5. Do commenters believe we should provide additional guidance relating to this requirement? If so, on which elements of the proposed requirement should we provide additional guidance? For example, is the proposed requirement that boards or advisers “select” a methodology sufficiently clear?

6. Are there investments for which it is not feasible to establish a methodology in advance? If so, how should the rule address such situations? Is it clear what new investment types a

fund may “intend” to invest in? Should we provide any further guidance on this? What processes do funds currently follow before investing in new types of investments to help to ensure that, after making the investment, the board will be in a position to determine fair value if required?

3. Testing of Fair Value Methodologies

The proposed rule would require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value.
56

This requirement is designed to help ensure that the selected fair value methodologies are appropriate and that adjustments to the methodologies are made where necessary. We believe that the specific tests to be performed and the frequency with which such tests should be performed are matters that depend on the circumstances of each fund and thus should be determined by the board or the adviser. The proposed rule would require the identification of (1) the testing methods to be used, and (2) the minimum frequency of the testing.
57

We believe that the results of calibration and back-testing can be particularly useful in identifying trends, and also have the potential to assist in identifying issues with methodologies applied by fund service providers, including poor performance or potential conflicts of interest.
58

For example, if a specific methodology consistently over-values or under-values one or more fund investments as compared to observed transactions, the board or adviser should investigate the reasons for this difference. We recognize, however, that back-testing may be less useful for portfolio holdings that trade infrequently.
59

56
Proposed rule 2a-5(a)(3).

57

Id.
Calibration can assist in assessing whether the fund's valuation technique reflects current market conditions, and also whether any adjustments to the valuation technique are appropriate. “Calibration” for these purposes is the process for monitoring and evaluating whether there are material differences between the actual price the fund paid to acquire portfolio holdings that received a fair value under the Act and the prices calculated for those holdings by the fund's fair value methodology at the time of acquisition.

58
Back-testing involves a comparison of the fair value ascribed to the fund's investment against observed transactions or other market information, such as quotes from dealers or data from pricing services. One common form of back-testing is “disposition analysis,” which compares a fair value as determined using a fair value technique with the price obtained for the security upon its disposition by the fund.

59

See
In re Morgan Asset Management,
supra
footnote 9 (back-testing by the fund “only covered securities after they were sold; thus, at any given time, the Valuation Committee never knew how many securities' prices could ultimately be validated by it.”).

We request comment on the proposed rule's requirement to test the appropriateness and accuracy of the fair value methodologies.

7. Should the rule require particular testing types or minimum testing frequencies? For example, should we require tests to occur at least weekly, monthly, or quarterly? If so, should the frequency required be dependent upon the type of instrument? Should the rule require all funds to use certain types of testing, such as back testing and calibration, at a minimum? Are certain types of methodology testing inappropriate or irrelevant for certain investment types?

8. What other types of testing of fair value methodologies are commonly used?

9. Should the rule require specified actions based on the results of the testing? If so, what would those actions be?

4. Pricing Services

To obtain valuation information, particularly for thinly traded or more complex assets, pricing services, may be used. Pricing services are third-parties that regularly provide funds with information on evaluated prices, matrix prices, price opinions, or similar pricing estimates or information to assist in determining the fair value of fund investments.
60

Accordingly, the proposed rule would provide that determining fair value in good faith requires the oversight and evaluation of pricing services, where used.
61

This provision is designed to help ensure that pricing information received from pricing services serves as a reliable input for determining fair value in good faith.

60

See
2014 Money Market Fund Release,
supra
footnote 14, at section III.D.2.b.

61
Proposed rule 2a-5(a)(4).

For funds that use pricing services, the proposed rule would require that the board or adviser establish a process for the approval, monitoring, and evaluation of each pricing service provider. The board or adviser generally should take into consideration factors such as (i) the qualifications, experience, and history of the pricing service; (ii) the valuation methods or techniques, inputs, and assumptions
62

used by the pricing service for different classes of holdings, and how they are affected as market conditions change; (iii) the pricing service's process for considering price “challenges,”
63

including how the pricing service incorporates information received from pricing challenges into its pricing information; (iv) the pricing service's potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and (v) the testing processes used by the pricing service.

62
In considering a pricing service's valuation methods or techniques, inputs, and assumptions, the fair value policies and procedures generally should address whether the pricing service is relying on inputs or assumptions provided by the adviser.

63
Price challenges involve, for example, the fund disagreeing with an evaluated price provided by a pricing service and providing additional information to the service suggesting that the provided evaluated price is not correct.

In addition, there may be times when pricing information from a pricing service differs materially from the board's or adviser's view of the fair value of the investment, and the board or adviser may seek to contact the pricing service to question the basis for the pricing information. As such, the proposed rule would require the establishment of criteria for the circumstances under which price challenges typically would be initiated (
e.g.,
establishing objective thresholds).

We request comment on the proposed rule's requirement to oversee pricing services.

10. Do commenters agree that the proposed rule should require oversight of pricing service providers, if used? Should the rule cover any service providers other than pricing services? If so, which service providers should be included? Should the rule further clarify who qualifies as a pricing service?

11. Should there be a specific requirement in the rule to periodically review the selection of the pricing services used and to evaluate other pricing services?

5. Fair Value Policies and Procedures

Proposed rule 2a-5 would require written policies and procedures addressing the determination of the fair value of the fund's investments (“fair value policies and procedures”).
64

The proposed rule would require the fair value policies and procedures to be reasonably designed to achieve compliance with the requirements of proposed rule 2a-5 discussed above. Requiring fair value policies and procedures that would be tailored to the proposed rule's requirements would help to ensure that a board or adviser, as applicable, determines the fair value of fund investments in compliance with the rule. Under the proposed rule, where the board determines the fair value of investments, the board-approved fair value policies and procedures would be adopted and implemented by the fund. Where the

board assigns fair value determinations to the adviser under proposed rule 2a-5(b), as discussed in section II.B, the fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight under rule 38a-1.
65

64
Proposed rule 2a-5(a)(5).

65
Proposed rule 2a-5(b).

Rule 38a-1 also would apply to a fund's obligations under the proposed rule. Rule 38a-1 requires a fund's board, including a majority of its independent directors, to approve the fund's policies and procedures, including those on fair value, and those of each investment adviser and other specified service providers, based upon a finding by the board that the policies and procedures are reasonably designed to prevent violation of the federal securities laws.
66

Rule 38a-1 also requires that the fund's CCO provide an annual report to the fund's board
67

that must address any material changes to compliance policies and procedures.
68

Rule 38a-1 would encompass a fund's compliance obligations with respect to proposed rule 2a-5, if adopted, and would require a fund's board to oversee compliance with the rule.
69

To the extent that adviser policies and procedures under proposed rule 2a-5 would otherwise be duplicative of fund valuation policies under rule 38a-1,
70

a fund could adopt the rule 2a-5 policies and procedures of the adviser in fulfilling its rule 38a-1 obligations.

66
Rule 38a-1(a)(2).

67
For UITs, the fund's principal underwriter or depositor conducts the functions assigned to management company boards under rule 38a-1. Rule 38a-1(b). This would continue if we adopt the proposed rule.

68

See
rule 38a-1(a)(4)(iii)(A).
See also
Compliance Rules Adopting Release,
supra
footnote 26, at n.33. “Material” in this context is a change that a fund director would reasonably need to know in order to oversee fund compliance.
See
rule 38a-1(e)(2). We have also said that “serious compliance issues” must be raised with the board immediately.
See
Compliance Rules Adopting Release,
supra
footnote 26, at n.33.

69
If adopted, rule 2a-5's requirements would supersede the Compliance Rules Adopting Release's discussion of specific policies and procedures required regarding the pricing of portfolio securities and fund shares.
Cf.
Compliance Rules Adopting Release, supra footnote 26, at nn.39-47 and accompanying text.

70

See generally
footnote 108.

We request comment on the proposed fair value policies and procedures requirement.

12. Are there specific elements that the proposed fair value policies and procedures should include other than the required elements of proposed rule 2a-5(a)?

13. Are we sufficiently clear on the interaction between rule 38a-1 and the policies and procedures under proposed rule 2a-5? Should we provide any further guidance on their interaction?

6. Recordkeeping

Proposed rule 2a-5 would require that the fund maintain certain records.
71

Specifically, the proposed rule would require the maintenance of:

71
Proposed rule 2a-5(a)(6). Under the proposed rule, the fund would maintain the required records both where the board itself determines the fair value of investments and where it assigns fair value determinations to an adviser under proposed rule 2a-5(b), as discussed at
infra
section II.B.6.

•
Supporting Documentation.
Appropriate documentation to support fair value determinations, including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations, as well as any necessary or appropriate adjustments in methodologies, for at least five years from the time the determination was made, the first two years in an easily accessible place; and

•
Policies and Procedures.
A copy of policies and procedures that would be required under the proposed rule that are in effect, or that were in effect at any time within the past five years, in an easily accessible place.

Funds and advisers currently are required to retain certain documentation related to fund valuation.
72

Documents often provide the primary means to demonstrate whether portfolio holdings have been valued in a manner consistent with applicable law, any valuation compliance policies and procedures, and any disclosures. They also provide evidence to the fund's auditors in performing their duties related to the audit of the fund's financial statements and assist the fund's CCO in the preparation of compliance reports to the board. The Commission has brought enforcement actions in cases where it alleged that appropriate documentation relating to valuation was not maintained by a fund or adviser or obtained by auditors.
73

72
Rule 38a-1(d) requires the maintenance of certain records, including copies of: All compliance policies and procedures adopted by the fund that are in effect or were in effect at any time during the last five years; materials provided to the board in connection with their approval of fund and service provider policies and procedures under the rule; the CCO's annual report to the board; and any records documenting the board's annual review of fund and service provider compliance policies and procedures under the rule. Rule 204-2 under the Advisers Act similarly requires an adviser to maintain copies of the adviser's compliance policies and procedures that are in effect or were in effect at any time during the last five years and any records documenting its annual review of such policies and procedures.
See
17 CFR 275.204-2.
See also
Compliance Rules Adopting Release,
supra
footnote 26, at section II.D. The funds' and advisers' records may be retained electronically.
See id.
(discussing rule 31a-2(f) under the Investment Company Act and rule 204-2(g) under the Advisers Act).

Other provisions of the federal securities laws require, among other things, that registered investment companies maintain appropriate books and records in support of the fund's financial statements and preserve for a specified period (generally six years) all schedules evidencing and supporting each computation of NAV.
See
Investment Company Act section 31(a) and rules 31a-1 and 31a-2. In addition, funds reporting under the Exchange Act must make and keep books, records, and accounts that accurately and fairly reflect their transactions and dispositions of their assets in reasonable detail. 15 U.S.C. 78m(b)(2)(A).

73

See
In re Allied Capital Corp., Securities Exchange Act Release No. 55931 (June 20, 2007) (settlement) (fund failed to maintain documentation required under the Exchange Act).
See also
In the Matter of Carroll A. Wallace, Securities Exchange Act Release No. 48372 (Aug. 20, 2003) (Commission opinion) (partner of accounting firm engaged in improper professional conduct in recklessly failing to obtain sufficient competent evidential material to support statements in the auditors' reports); In the Matter of Morgan Stanley, Securities Exchange Act Release No. 50632 (Nov. 4, 2004) (settlement) (financial services firm failed to maintain sufficient underlying documentation supporting certain valuations).

The proposed requirement to maintain appropriate documentation to support fair value determinations would include documentation that would be sufficient for a third party to verify the fair value determination. We understand that advisory personnel currently produce working papers supporting fair value determinations that include, for example, calibration and back-testing data as well as other information such as stale price analysis.
74

These records would be required to be maintained as supporting fair value determinations.
75

74
Stale price analysis can include an evaluation of whether a price quote that may be used to support a fair value price is sufficiently timely to be useful.

75
Proposed rule 2a-5(a)(6)(i).

We believe that it is appropriate for the proposed rule to include a recordkeeping provision to facilitate compliance with the proposed rule and to permit effective regulatory oversight. The proposed retention periods are designed to be consistent with the recordkeeping requirements in rule 38a-1(d), the compliance rule. As discussed above, the compliance rule requires the retention of, among other things, compliance policies and procedures (which would include those relating to valuation) and certain records.
76

We believe that this recordkeeping requirement would provide important investor protections and, because it would be consistent with current record retention practices under to rule 38a-1(d), would not impose overly burdensome recordkeeping costs.

76

See supra
footnote 72.

We request comment on the proposed recordkeeping provisions.

14. Are there any additional types of records that we should require? If so, which records and why?

15. Where the board assigns fair value determinations to an adviser under proposed rule 2a-5(b), should the rule require the adviser, rather than the fund, to maintain these records?

16. Are the proposed retention periods sufficient to evidence compliance? Why or why not? Should we require a longer (
e.g.,
six years) or shorter (
e.g.,
four years) retention period?

17. Are key terms used in this aspect of the proposal sufficiently understandable? For example, as stated above, “appropriate documentation to support fair value determinations” under the proposed recordkeeping requirement would include documentation that would be sufficient for a third party to verify the fair value determination. Should we define these or other terms or provide further guidance relating to them?

B. Performance of Fair Value Determinations

The Act assigns boards a critical role in connection with determinations of fair value.
77

Although the Commission has previously taken the position that a fund's board may not delegate the determination of fair value to anyone else,
78

the Commission has also recognized that compliance with the Act does not require the board to perform each of the specific tasks required to calculate fair value itself.
79

We believe that the Commission's prior guidance recognized that determinations of fair value often require significant resources and specialized expertise, and that in many cases it may be impracticable for directors themselves to perform every one of the necessary tasks without assistance. We expect that today determining fair value requires even greater resources and expertise than when ASR 113 and ASR 118 were issued. For this reason, in addition to providing requirements for determining fair value in good faith generally, the proposed rule also is designed to provide boards and advisers with a consistent, modern approach to the allocation of fair value functions, while also preserving a crucial role for boards to fulfill their obligations under section 2(a)(41) of the Act.

77
Section 2(a)(41)(B)(ii) provides that, when market quotations are not readily available, “value” means “fair value as determined in good faith by the board of directors.” Rule 2a-4 contains the same definition of fair value as section 2(a)(41)(B)(ii). 17 CFR 270.2a-4. The Commission has discussed the board's role in determinations of fair value in a number of Commission releases, including ASR 113, ASR 118, the Compliance Rules Adopting Release,
supra
footnote 26, and the 2014 Money Market Fund Release,
supra
footnote 14.

In addition to their role under the Act, boards may have liability under antifraud provisions of the federal securities laws if a fund's prospectus or other disclosures regarding valuation are not consistent with the fund's valuation practices.
See, e.g.,
15 U.S.C. 77k(a)(1).

78

See, e.g.,
2014 Money Market Fund Release,
supra
footnote 14, at nn.890 and 896 and accompanying text; In the Matter of Seaboard Associates, Inc. (Report of Investigation Pursuant to Section 21(a) of the Exchange Act), Investment Company Act Release No. 13890 (Apr. 16, 1984) (“The Commission wishes to emphasize that the directors of a registered investment company may not delegate to others the ultimate responsibility of determining the fair value of any asset not having a readily ascertainable market value, such as oil and gas royalty interests.”).

79
The Commission stated in ASR 118 that the board “may appoint persons to assist them in the determination of [fair] value, and to make the actual calculations pursuant to the board's direction”; however, “the findings of such individuals must be carefully reviewed by the directors in order to satisfy themselves that the resulting valuations are fair.”
See also
ASR 113 (“The actual calculations may be made by persons acting pursuant to the direction of the board.”).

Under the proposed rule, a board may choose to determine fair value in good faith for any or all fund investments by carrying out all of the functions required in paragraph (a) of the proposed rule, including, among other things, monitoring for circumstances that necessitate fair value, selecting valuation methodologies, and applying those methodologies.
80

However, a board would not be required to take this approach. We understand that, for practical reasons, few boards today are directly involved in the performance of the day-to-day valuation tasks required to determine fair value. Instead they enlist the fund's investment adviser to perform certain of these functions, subject to their supervision and oversight.
81

80
As discussed above, in this circumstance, the fund would, on behalf of the board, adopt and implement policies and procedures and keep records consistent with the requirements of paragraph (a) of the proposed rule.
See
proposed rule 2a-5(b).

81
For example, for a fund that issues redeemable securities, value must be calculated at least once each business day for each portfolio holding in order to calculate the fund's NAV. 17 CFR 270.22c-1(b)(1). Making these fair value determinations by themselves would therefore likely be impracticable for most, if not all, boards of such funds.

This allocation of functions is consistent with the framework created by the ASRs. We continue to believe that allocating day-to-day responsibilities to an investment adviser, subject to robust board oversight, is appropriate and consistent with the requirements of Act. The proposed rule is designed to provide a consistent framework for this allocation between boards and advisers, and to provide enhanced protections which we believe are consistent with the more modern approaches to fair value and compliance with the federal securities laws described below.

Accordingly, the proposed rule would permit a fund's board of directors to assign the fair value determination relating to any or all fund investments to an investment adviser of the fund, which would carry out all of the functions required in paragraph (a) of the proposed rule, subject to certain requirements enumerated in proposed paragraph (b).
82

A fund's board could make this assignment to a fund's primary adviser or one or more sub-advisers. For example, for a fund with a sub-adviser responsible for managing a portion of the fund's portfolio, the board could assign the determination of fair value for the investments in that portion of the fund's portfolio to that sub-adviser. As a result, a multi-manager fund could have multiple advisers assigned the role of determining fair value of the different investments that those advisers manage. Where the board assigns fair value determinations to multiple advisers, the fund's policies and procedures adopted under rule 38a-1 should address the added complexities of overseeing multiple assigned advisers in order to be reasonably designed to avoid violating the federal securities laws.
83

Any board assignment under the proposed rule would be subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability effectively to oversee the adviser's fair value determinations. We discuss each of these requirements below.

82
As noted above, because a UIT does not have a board of directors or an investment adviser, a UIT's trustee would conduct fair value determinations under the proposed rule.
See
proposed rule 2a-5(d).
See also supra
footnote 38.

83

See
rule 38a-1. These challenges include, for example, how to address reconciling differing opinions on the same investment (if applicable) and establishing clear reporting structures.

We request comment generally on the role of the board of directors when it does not assign the fair value determination to an adviser to the fund.

18. For boards that elect to conduct fair value determinations themselves, should we provide any guidance on the level of assistance they can receive from service providers, while fulfilling their obligations under section 2(a)(41)? Do we need to provide any guidance on how a board should obtain and oversee such assistance if needed? If so, what guidance should we provide?

1. Board Oversight

Where the board assigns fair value determinations to an adviser, the proposed rule would require the board to satisfy its statutory obligation with respect to such determinations by overseeing the adviser. 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, the appropriateness of the fair value determination process, and the skill and resources devoted to it.
84

Further, in our view effective oversight cannot be a passive activity. Directors should ask questions and seek relevant information. The board should view oversight as an iterative process and seek to identify potential issues and opportunities to improve the fund's fair value processes.
85

The proposed rule would require the adviser to report to the board with respect to matters related to the adviser's fair value process, in part to ensure that the board has sufficient information to conduct this oversight.
86

Boards should also request follow up information when appropriate and take reasonable steps to see that matters identified are addressed.
87

84

See generally
Investment Company Governance, Investment Company Act Release No. 26520 (July 27, 2004) (“Governance Release”).

85

See, e.g.,
Derivatives Release,
supra
footnote 17, at section II.C.

86
Proposed rule 2a-5(b)(1).

87
For example, we have stated that independent directors should “bring to the boardroom `a high degree of rigor and skeptical objectivity to the evaluation of management and its plans and proposals,' particularly when evaluating conflicts of interest.”
See
Governance Release,
supra
footnote 84.

We would expect that boards engaged in this process would use the appropriate level of scrutiny based on the fund's valuation risk, including the extent to which the fair value of the fund's investments depend on subjective inputs. For example, a board's scrutiny would likely be different if a fund invests in publicly traded foreign companies than if the fund invests in private early stage companies. As the level of subjectivity increases and the inputs and assumptions used to determine fair value move away from more objective measures, we expect that the board's level of scrutiny would increase correspondingly.
88

88
For a discussion of fund fair value risks generally, see
supra
section II.A.1.

We also believe that, consistent with their obligations under the Act and as fiduciaries, boards should seek to identify potential conflicts of interest, monitor such conflicts, and take reasonable steps to manage such conflicts.
89

In so doing, the board should serve as a meaningful check on the conflicts of interest of the adviser and other service providers involved in the determination of fair values.
90

In particular, the fund's adviser may have an incentive to improperly value fund assets in order to increase fees, improve or smooth reported returns, or comply with the fund's investment policies and restrictions.
91

Other service providers, such as pricing services or broker-dealers providing opinions on prices, may have incentives (such as maintaining continuing business relationships with the adviser) or may otherwise be subject to pressures to provide pricing estimates that are favorable to the adviser.
92

In overseeing the adviser's process for making fair value determinations, the board should understand the role of, and inquire about conflicts of interest regarding, any other service providers used by the adviser as part of the process, and satisfy itself that any conflicts are being appropriately managed.

89

See, e.g.,
Governance Release,
supra
footnote 87 (“ . . . state law duties of loyalty and care . . . oblige directors to act in the best interest of the fund when considering important matters the Act entrusts to them, such as approval of an advisory contract and the advisory fee.”).

90

See, e.g., id.
(“. . . the Act and our rules rely heavily on fund boards of directors to manage the conflicts of interest that advisers have with funds they manage.”).
See also
Division of Investment Management, SEC, Protecting Investors: A Half Century of Investment Company Regulation, 252 (1992) (“the [Investment Company] Act . . . imposes requirements that assume the standard equipment of a corporate democracy: a board of directors . . . whose function is to oversee the operations of the investment company and police conflicts of interest. . . [W]e believe that independent directors perform best when required to exercise their judgment in conflict of interest situations”);
see also
Investment Company Institute Independent Directors Council, Fair Valuation Series: The Role of the Board at 10 (2006) (“IDC Role of the Board”), available at
http://www.ici.org/pdf/06_fair_valuation_board.pdf
(“Investment professionals, for example, can be important sources of information about the value of securities. At the same time, conflict of interest concerns may be raised when investment professionals assign fair valuations that dramatically boost a fund's performance. These concerns may be heightened when the compensation of the investment professionals is based on the fund's performance. To address these potential concerns, boards may want to consider whether investment professionals responsible for managing a particular fund should have sole or primary authority for determining securities valuations for that fund.”).

91

See, e.g.,
Piper,
supra
footnote 7. For conflicts of the fund's portfolio manager, see
infra
footnote 120 and accompanying text.

92

Cf.
In re Morgan Asset Management,
supra
footnote 9, at 7 (broker-dealer “induced to provide interim price confirmations that were lower than the values at which the Funds were valuing certain bonds, but higher than the initial confirmations that the [broker-dealer] had intended to provide”).

Boards should probe the appropriateness of the adviser's fair value processes. In particular, boards should periodically review the financial resources, technology, staff, and expertise of the assigned adviser, and the reasonableness of the adviser's reliance on other fund service providers, relating to valuation.
93

In addition, boards should consider the adviser's compliance capabilities that support the fund's fair value processes, and the oversight and financial resources made available to the CCO relating to fair value.

93

See
In re Morgan Asset Management,
supra
footnote 9 (“the Valuation Committee left pricing decisions to lower level employees in Fund Accounting who did not have the training or qualifications to make fair value pricing determinations”).

Boards should also consider the type, content, and frequency of the reports they receive. The proposed rule would require reporting to the board (both periodically and promptly) regarding many aspects of the adviser's fair value determination process as a means of facilitating the board's oversight as discussed below. While a board can reasonably rely on the information provided to it in summaries and other materials provided by the adviser and other service providers in conducting its oversight, it is incumbent on the board to request and review such information as may be necessary to be fully informed of the adviser's process for determining the fair value of fund investments. Further, if the board becomes aware of material matters (whether the board identifies the matter itself or the fund's CCO or adviser or another party identifies the issue), we believe that in fulfilling its oversight duty the board must inquire about such matters and take reasonable steps to see that they are addressed.
94

94
Proposed rule 2a-5(b)(1)(ii).

We request comment on this aspect of the proposal:

19. Should we permit boards to fulfill the statutory function to fair value one or more fund investments in good faith by assigning that fair value determination to an adviser to the fund as described above? Would the proposed rule change the services provided by advisers with respect to valuation and, if so, would such a change have any implications for the board's consideration of the advisory contract under section 15(c) of the Act (
e.g.,
changes in compensation)? If so, are there additional responsibilities under the proposed rule for which advisers would seek additional compensation?

20. The rule would permit boards to assign the determination of fair value only to an adviser to the fund. Are there other parties to which we should permit boards to assign such determinations? For example, would it be appropriate to allow boards to assign these determinations to pricing vendors or accounting firms? Are there any parties that fund boards currently rely upon to help make fair value determinations that could adequately be relied upon in the same way as a fund adviser? If we do permit other parties to be assigned the determination of fair value under the final rule, what safeguards, if any, should we include to ensure that the determinations of fair value in good faith are conducted consistent with the proposed rule? For example, should we only permit assignment to non-advisers if they have a fiduciary duty to the fund or if they are regulated by the Commission? Why or why not?

21. As proposed, the rule would require that an assignment to an investment adviser cover all elements of paragraph (a) for a given investment or investments. Should we permit the assignment of particular elements of paragraph (a) to an investment adviser or different advisers? If so, what safeguards should we include to ensure that the determinations of fair value in good faith are conducted consistent with the proposed rule?

22. The proposed rule would permit boards to assign the determination of fair value in good faith to the fund's primary investment adviser or one or more sub-advisers. Should we allow boards to assign this process to sub-advisers, or only allow the fund's primary investment adviser to fulfill this role? Why or why not? Should we impose any obligations for the adviser to oversee any assigned sub-adviser? If so, what obligations? For example, should we require in the rule that a fund must establish reconciliation procedures to address situations where sub-advisers have differing views on the fair value of a fund investment?

23. Should we limit the assignment to a single adviser in order to minimize the issues relating to having multiple advisers assigned determinations of fair value under the Act? If so, why? Conversely, should we require additional safeguards in the case of multiple assigned advisers? If so, what should they be? For example, should we require specific policies and procedures or reports, beyond those already required, or those that would be required, under rule 38a-1 or the proposed rule?

24. Should we permit or require anyone other than the trustee of a UIT to perform the functions described in paragraph (a), such as a person appointed by the trustee? Should we, for example, allow the trustee to assign these determinations to the UIT's sponsor, principal underwriter, or depositor? Would these or any other parties be better equipped to determine the fair value of investments? If the rule were to permit the trustee to assign these determinations to another person, should we require that person to report to the trustee like the adviser would to a board for management companies? What kind of oversight responsibilities should the trustee have? Are there other modifications to the proposed rule that we should make to apply it to UITs given their unmanaged nature and different governance structure compared to other funds?

25. Is our proposed requirement that a board “oversee” the adviser sufficient? Should we prescribe in rule 2a-5 additional steps to mitigate the risk of conflicts of interest and other issues related to the fair value process, such as a third party review of the fair value process, or an attestation by the adviser? If so, what should those steps be? What additional costs would they add, and who would bear those costs?

26. As noted above,
95

the proposed rule would define “board” as either the fund's entire board of directors or a designated committee of such board composed of a majority of directors who are not interested persons of the fund.
96

Are there any actions required in the proposed rule that we should require the full board, rather than a committee, to perform?

95

See supra
footnote 33.

96
Proposed rule 2a-5(e)(3).

27. Would boards assign the fair value determination to an investment adviser with respect to some investments and determine the fair value of other investments themselves? If so, what types of investments would boards most likely assign to an adviser and under what circumstances, and which would they fair value themselves? Should we provide any additional guidance as to how boards would determine the fair value of fund investments where the board does not assign those determinations to an adviser?

2. Board Reporting

Effective information flow is a critical part of a board's oversight of an adviser to whom it has assigned fair value determinations. We understand that boards currently receive a variety of reports from the adviser outlining the operation of the fund's valuation process.
97

While some of the reports currently provided may be useful for boards, others may contain detailed trade-by-trade information, or other day-to day operational data that may not be effective in facilitating the board's oversight. We believe that it is important for the board to receive relevant and tailored information from the adviser to ensure that the board has sufficient insight and data to exercise the oversight contemplated by the proposed rule. We also believe that these reports should familiarize directors with the salient features of the adviser's process and provide them with an understanding of how that process addresses the requirements of rule 2a-5. Therefore we are proposing the board reporting requirements discussed below.
98

These requirements are intended to help ensure that boards receive the amount and type of information that they find most valuable in overseeing the adviser.
99

97

See
“Practical Guidance for Fund Directors on Valuation Oversight,” Report of the Mutual Fund Directors Forum (June 2012) (available at
https://mfdf.org/images/Newsroom/Valuation-web.pdf
) (“MFDF Valuation Report”) at 14-15.

98
This would be in addition to any reports required under rule 38a-1.
See
Compliance Rules Adopting Release,
supra
footnote 26, at section II.A.2.c.

99
The requirements we propose in this document would be minimum requirements and fund boards could always ask for additional reporting from advisers.
See infra
footnote 110 and accompanying text.

The proposed rule would require the adviser's reports to include such information as may be reasonably necessary for the board to evaluate the matters covered in the reports.
100

This requirement is designed to provide the fund's board with sufficient context for the matters covered in the report. This context is necessary in order to facilitate the board's oversight by providing them with enough information to determine whether to ask additional questions or request additional information, as appropriate. For example, we do not believe that it would be consistent with the proposed rule for the adviser to report that there is a new material conflict of interest without the context necessary for the board to evaluate what effect the conflict would have on the adequacy and effectiveness of the adviser's process for determining fair value. The content of the periodic or prompt reports and supplemental information under the proposal could take the form of narrative summaries,

graphical representations, statistical analyses, dashboards, or exceptions-based reporting, among other methods.

100
Proposed rule 2a-5(b)(1). This is similar to the approach we have adopted with regard to money market stress testing and proposed with regard to board oversight of derivatives risk managers.
See
2014 Money Market Fund Release,
supra
footnote 14, and Derivatives Release,
supra
footnote 17.

a. Periodic Reporting

Proposed rule 2a-5 would require the adviser, at least quarterly, to provide the board a written assessment of the adequacy and effectiveness of the adviser's process for determining the fair value of the assigned portfolio of investments.
101

We understand that the materials currently prepared for boards for purposes of board meetings can include detailed information regarding the fair value process, including a list of each individual portfolio holding that received a fair value since the prior board meeting (
e.g.,
during the quarter).
102

Although some boards may find this specific information useful, we are not proposing to mandate this level of detailed reporting because we believe that the board's oversight may be better facilitated through the use of more targeted forms of reporting designed to identify trends, exceptions, or outliers, and generally provide a sufficient overview of the current state of the fair value process.
103

Accordingly, the proposed rule would require the adviser's periodic reports to provide the adviser's evaluation of the adequacy and effectiveness of its process for determining fair value. The periodic reports would be required to, at a minimum, include a summary or description of the following information:

101
Proposed rule 2a-5(b)(1)(i).

102

See
MFDF Valuation Report,
supra
footnote 97, at 14.

103
Fund boards could always request additional information if they so choose. Proposed rule 2a-5(b)(1)(i)(F).

•
Material Valuation Risks.
The assessment and management of material valuation risks that would be required under the proposed rule. This would include any material conflicts of interest of the investment adviser and any other service provider.
104

As discussed above, we believe that assessing and managing identified valuation risks is an important element for determining fair value in good faith because valuation risks that are not effectively managed can make it more likely that the adviser has incorrectly valued an investment.

104
Proposed rule 2a-5(b)(1)(i)(A).
See supra
section II.A.1 discussing this process. For example, the adviser could discuss instances where it challenged the pricing information provided by an affiliated or third party vendor.

•
Material Changes to or Material Deviations from Methodologies.
Any material changes to, or material deviations from, the fair value methodologies established under the proposed rule.
105

This requirement would keep boards informed of such changes or deviations, which may show that the methodologies need to be updated or adjusted, and provide an opportunity for a board to ask questions regarding the reasons for any change or deviation.

105
Proposed rule 2a-5(b)(1)(i)(B). For example, a report could discuss when key inputs or assumptions are changed and the reasons for the changes. We believe that both a material change and the reason for it would be information that may be reasonably necessary for the board to evaluate such changes.

•
Testing Results.
The results of any testing of fair value methodologies as part of the required fair value policies and procedures.
106

As discussed above, the requirement to test the appropriateness and accuracy of the methodologies used to calculate fair value is designed to help ensure that the selected fair value methodologies are appropriate and that adjustments to the methodologies are made where necessary.

106
Proposed rule 2a-5(b)(1)(i)(C).

•
Resources.
The adequacy of resources allocated to the process for determining the fair value of the fund's assigned investments, including any material changes to the roles or functions of the persons responsible for determining the fair value.
107

The adviser's assessment of the adequacy of these resources may inform a board in determining the level of scrutiny to apply in overseeing an adviser's fair value determinations.

107
Proposed rule 2a-5(b)(1)(i)(D). For example, an adviser should disclose to the board when the adviser seeks to hire a new pricing service to cover a new asset type or when replacing a person with a background in valuation with a person without that background in a position of authority regarding the adviser's fair value process.
See also
proposed rule 2a-5(b)(2).

•
Pricing Services.
Any material changes to the adviser's process for overseeing pricing services,
108

as well as any material events related to its oversight of such services, such as changes of service providers used or price overrides.
109

This information is designed to help the board oversee the adviser's use of pricing services, if applicable, and to help ensure that pricing information received from service providers serves as a reliable input for determining fair value in good faith.

108
If the board assigns the fair value determination to an adviser under the proposed rule, the board would generally be aware of an adviser initially appointing, and the establishment of the process for overseeing, a pricing service as part of its oversight and approval of the adviser's policies and procedures under rule 38a-1. As a result, we are not specifically proposing to require that information be included in these periodic reports.

109
Proposed rule 2a-5(b)(1)(i)(E). There may be times when pricing information from a pricing vendor differs materially from the adviser's view of the then-current fair value of the portfolio holding, and the adviser may seek to contact the pricing vendor to question the basis for the pricing information. Because this difference in pricing suggests that further inquiry is needed to assess the adequacy of the fair value process when these conflicts occur, we are proposing to require this reporting.

•
Other Requested Information.
Any other materials requested by the board related to the adviser's process for determining the fair value of fund investments.
110

110
Proposed rule 2a-5(b)(1)(i)(F).

These requirements collectively are designed to help ensure that boards obtain the information that they need to exercise their statutory and fiduciary duties and to oversee an adviser. They are intended to supplement, not replace, this oversight. Boards should critically review the information provided to them, particularly with regard to an adviser's reporting on its own conflicts of interest, and request any information that they feel is necessary to conduct that oversight. For example, in addition to the specific items listed above,
111

a board could review and consider, if relevant:

111
Boards and fund CCOs may also consider requesting or including items such as the examples given in the bullet list below, if relevant, as part of the CCO's annual reports to the board under rule 38a-1(a)(4)(iii).

• Summaries of adviser price challenges to pricing information provided by third-party vendors and of price overrides, including back-testing results related to the use of price challenges and overrides;

• Specific calibration and back-testing data, including in the case of back-testing whether fair value prices moved in the same direction (relative to the prior market prices) as the portfolio holdings' next actual market prices, whether fair value prices were closer to the portfolio holdings' next actual market prices than the prior market prices (regardless of the direction), and whether the difference between the fair value prices and the subsequent prices was greater than pre-established tolerance levels;
112

112

See supra
footnote 57. In these cases, reports on back-testing could indicate whether fair value is being compared to actual sales prices or to pricing information from pricing services and dealers. In the latter case, the reports could state whether dealer prices are actual bids or firm commitments or are indicative or accommodation quotes that merely represent the opinion of the dealer.

• Reports regarding portfolio holdings for which there has been no change in price or for which investments have been held at cost for an extended period of time (“stale prices”);

• Reports regarding portfolio holdings whose price has changed outside of

predetermined ranges over a set period of time;

• Narrative summaries or reports on pricing errors, including the date of any error, the cause, the impact on the fund's NAV, and any remedial actions taken in response to the error;

• Reports on the adviser's due diligence of pricing services used by the fund;

• The results of testing by the fund's independent auditor provided to the audit committee;

• Reports analyzing trends in the number of the fund's portfolio holdings that received a fair value, as well as the percent of the fund's assets that received a fair value; and

• Reports on the number and materiality of securities whose fair values were determined based on information provided by broker-dealers; the broker-dealers most frequently used for this purpose; and the results of back-testing on the information they provided.

We request comment on our proposed requirement that advisers periodically provide a written evaluation of the adequacy and effectiveness of the adviser's process for determining the fair value of the assigned portfolio of investments, including, at a minimum, certain specified summaries or descriptions.

28. Is the proposed periodic reporting requirement appropriate? What resources would be required for an adviser to provide the required quarterly assessment of the adequacy and effectiveness of the adviser's process? Are there additional or different matters that we should require advisers to address in the periodic reports? Are there some items that we should not require? If so, which, and why?

29. Should we require a different minimum reporting frequency for periodic reports? Should we, for example, require advisers to provide these reports monthly or in connection with each regularly scheduled board meeting? Should we require some or all of the specified information to be provided less frequently, such as annually?

30. Is what should be included in an assessment clear? Should we include additional guidance to explain what this entails? Are the other key terms used in the proposal, such as “assess,” and “material” sufficiently understood or is further guidance advisable for those terms? Should they be defined in the rule, and, if so, how? Should the rule use different terms, and, if so, which terms?

31. Are there circumstances in which boards should receive specific information on each individual portfolio holding that received a fair value during the quarter or certain such holdings?

32. We are proposing to require that all price overrides be reported as supplemental information to the board as part of the periodic report. Should we limit which price overrides must be reported, and, if so, how? Alternatively or in addition, should we require reporting regarding all price challenges, even those that do not lead to overrides?

33. Is there additional specific information that we should require to be part of these periodic reports? Are there any other reports that some boards currently receive that should be required under the proposed rule?

34. In light of their importance, should the rule impose specific requirements beyond reporting regarding pricing services? For example, should any pricing services used be explicitly approved by the board? Should there be a required finding or report by the adviser as to pricing services' adequacy and effectiveness?

b. Prompt Board Reporting

We also believe that it is important for the adviser to notify the board of certain issues as they arise that may require their immediate attention. Proposed rule 2a-5 would require that the adviser promptly report to the board in writing on matters associated with the adviser's process that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments, including a significant deficiency or a material weakness in the design or implementation of the adviser's fair value determination process or material changes
113

in the fund's valuation risks.
114

These reports, like the periodic reports discussed above, also must include such information as may be reasonably necessary for the board to evaluate the matter covered in the report.

113
For example, a significant increase in price challenges or overrides likely would reflect a material change to the fund's valuation risks that should be promptly reported to the board,

114
Proposed rule 2a-5(b)(1)(ii).

“Could have materially affected” is intended to capture certain circumstances where, for example, a matter was detected which affected one security and which may not be material on its own, but, had the matter not been identified, could have materially affected the larger assigned portfolio of investments or some subset of that portfolio.
115

This concept is not intended to mandate reporting in circumstances where, at the time the matter was detected, it did not seem that the matter would materially affect the fair value of the assigned portfolio but the matter later ended up having such an effect.

115

See
PCAOB AS 2201 An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements, Appendix A—Definitions .A7 (defining “material weakness” and “reasonable possibility”).
See also
Sarbanes-Oxley Act,
supra
footnote 21, at Title III Sec. 302(a)(5).

We are proposing to require the adviser to provide these reports promptly, but in no event later than three business days after the adviser becomes aware of the matter, rather than waiting until the next periodic report.
116

We believe it is appropriate that the board receive prompt reports regarding matters that materially affect fair value determinations because the proposed rule would allow the board to assign to an adviser fair value determinations otherwise allocated to the board under the Act, and there may arise an issue of such importance that requires prompt board attention. We recognize that the kind of matters that may require this prompt reporting (
i.e.,
outside of the periodic reports) may vary. Some situations may warrant an immediate report, while in other cases it may be appropriate for the adviser to take some additional time to evaluate how to address the matter before engaging the board. We believe that requiring such a report to be “prompt,” but in no event later than three business days after the adviser becomes aware, balances the need for the board to be timely informed of material valuation issues, while allowing the adviser to evaluate and respond appropriately.

116

Id.

We also understand, however, that there may be some circumstances when an adviser becomes aware of an issue that may affect fair value of the portfolio but that the materiality of a given event may be in question. In such a case, an adviser may need additional time to determine and verify whether an event has or could materially affect the fair value of the portfolio assigned to the adviser. Accordingly, we believe that if an adviser needs some reasonable amount of time after becoming aware of the matter to verify and determine its materiality, that verification period would not be counted as part of the “prompt” trigger period. In general, we believe that this verification and final determination process should be completed within three business days or less, including the day that the adviser became aware of the triggering event. Therefore, any prompt reports generally should occur no more than three business days after the adviser becomes

aware of the event, but the adviser may, to the extent necessary, take limited additional time (but in no event more than three business days) for the verification and final determination process.

We request comment on our proposed requirement regarding prompt reporting on certain matters associated with the adviser's process that materially affect, or could have materially affected, the fair value of the assigned portfolio of fund's investments.

35. Are the proposed prompt reporting requirements appropriate? Are there additional or different matters that we should require advisers to address in their prompt reports?

36. Should the trigger for prompt reporting be tied to a specific bright line or instead be dependent on facts and circumstances? For example, instead of the trigger being when the adviser becomes aware of the matter should it instead be when the event occurs? If so, would advisers reasonably be able to know when such events occur such that they could report in a timely fashion? Alternatively, should it be when the adviser determines and verifies the impact of the event regardless of how long it takes after the adviser becomes aware of the matter?

37. Are the standards of “materially affecting” or “could have materially affected” sufficiently understood? Should we provide more context on what these terms mean, specifically as they relate to the context of material weaknesses? Should we instead adopt a different standard, such as one that uses specific triggers, to identify matters for prompt reporting? If so, which triggers? For example, should we instead require reporting when a specific number of price overrides have occurred?

38. Should we identify any other issues that the adviser should report promptly to the board? For example, instead of requiring any changes to the fund's fair value methodologies to be reported during the periodic reports, should we instead require that they also be reported promptly? Alternatively, are there matters that would be required to be reported promptly that should instead be reported as part of the periodic report?

39. Is the specified timeline for prompt reporting appropriate or should we consider different time frames? For example, should we require that an adviser report to the board within 1 or 10 business days? Should the time frame be different for certain types of circumstances? If so, which ones?

40. Will advisers be able to make the appropriate determinations in the limited time discussed above? Will advisers need more than three business days to make such a materiality decision? Is three days too long? Should we specify a time for making materiality decision in the rule?

41. The proposed rule would require all reports to be in writing, including prompt reports. Should we provide that in the case of prompt reports, advisers could make oral reports so long as adequate records are kept?

42. Should we require that, if the report is not made to the full board, the designated board committee make a report to the full board within a specified time frame, such as at the next regularly scheduled meeting?

43. Should we permit the adviser to make prompt reports to a pre-identified individual director? What controls should we require if we did permit this? For example, should that director be required to be one of the independent directors?

3. Specification of Functions

If the board assigns the fair value determination requirements for one or more fund investments to an adviser, the proposed rule would require the adviser to specify the titles of the persons responsible for determining the fair value of the assigned investments, including by specifying the particular functions for which the persons identified are responsible.
117

If the adviser uses a valuation committee or similar body to assist in the process of determining fair value, the fair value policies and procedures generally should describe the composition and role of the committee, or reference any related committee governance documents as appropriate. In addition, the fair value policies and procedures also should identify the specific personnel with duties associated with price challenges, including those with the authority to override a price, and the roles and responsibilities of such persons, and establish a process for the review of price overrides.
118

117
Proposed rule 2a-5(b)(2).

118

See also
proposed rule 2a-5(a)(4).

In addition, the proposed rule would require the adviser to reasonably segregate the process of making fair value determinations from the portfolio management of the fund.
119

One significant source of potential adviser conflicts of interest in the fair value determination process is the level and kinds of input that fund portfolio managers or persons in related functions have in the design or modification of fair value methodologies, or in the calculation of specific fair values.
120

In many circumstances, the fund's portfolio manager may be the most knowledgeable person at an investment adviser regarding a fund's portfolio holdings. For this reason, it may be appropriate for portfolio managers to provide input into the process for determining the fair value of fund investments. On the other hand, because portfolio management personnel are often compensated in part based on the returns of the fund, a portfolio manager's incentives may not be fully aligned with the fund's with respect to determination of fair value, and a portfolio manager therefore should not be making the fair value determinations.
121

119

See
In re Morgan Asset Management,
supra
footnote 9.

120

Id.
at 4 (fund's portfolio manager “actively screened and influenced a broker-dealer to change the price confirmations [and] failed to advise . . . when he received information indicating that the Fund's prices for certain securities should be reduced.”).

121
In addition, as the person most directly responsible for the fund's investments, the portfolio manager may also be concerned about the reputational or career implications of the fund's performance, or its compliance with investment limitations, which can provide an incentive to smooth returns or otherwise misvalue portfolio holdings.

Further, we believe that a fund generally should consider the extent of influence portfolio managers may have on administration of the fair value process, and seek to provide independent voices and administration of the process as a check on any potential conflicts of interest to the extent appropriate.
122

Separation of functions facilitates these important checks and balances, and funds could institute this proposed requirement through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel. The proposed rule would require reasonable segregation of functions, rather than taking a more prescriptive approach, such as requiring funds to implement strict protocols regarding communications between specific personnel, to allow funds to structure their fair value determination process and portfolio management functions in ways that are tailored to each fund's facts and circumstances, including the size and resources of the fund's adviser. In this regard, the reasonable segregation requirement is not meant to indicate that portfolio management must necessarily be subject to a communications “firewall.” We recognize the important perspective and insight regarding the value of fund holdings that portfolio management

personnel can provide. Accordingly, this segregation requirement would not prevent portfolio managers from providing inputs that are used in the fair value determination process, as noted above. Instead, this reasonable segregation requirement is designed to help reduce and manage potential conflicts of interest. Keeping the functions reasonably segregated in the context of fair value determinations should help mitigate the possibility that these competing incentives diminish the effectiveness of fair value determinations.

122

See
Liquidity Risk Management Release,
supra
footnote 3, at section III.H.1.

We request comment on this proposed requirement.

44. Should the rule require assigned advisers to reasonably segregate the process of making fair value determinations from the portfolio management of the fund? Would this pose any difficulty for particular types of entities, for example funds managed by small advisers?

45. Is there a better way to prevent conflicts between a portfolio manager's incentives and a fund's interest, for example, in determination of investment values that do not result in dilution of purchasing or redeeming investors? Should we provide any additional clarification regarding the proposed reasonable segregation requirement? If so, what changes should we make? Should we add or change any specific requirements? For example, should we prohibit portfolio management from having any involvement in the fair value process or should we generally prohibit their involvement outside of certain situations beyond making fair value determinations? If so, what level of involvement should we permit? Further, should we exempt smaller advisers from this requirement or clarify that this is a key risk and thus, where feasible, such personnel should be segregated, without making segregation an explicit regulatory requirement? Are there effective steps, other than segregation, that funds currently use to manage the potential conflicts of portfolio management personnel that the rule should require instead of segregation? If so, what are they and why should they be required instead?

4. Records of Assignment

Under the proposed rule, in addition to the records that would need to be kept as part of a good faith determination of fair value generally, a fund must also keep records related to the fair value determinations assigned to the adviser. Specifically, the fund would be required to: (1) Keep copies of the reports and other information provided to the board required by the rule and (2) a specified list of the investments or investment types whose fair value determinations have been assigned to the adviser pursuant to the requirements of the proposed rule.
123

In each case, these records would be required to be kept for at least five years after the end of the fiscal year in which the documents were provided to the board or the investments or investment types were assigned to the adviser, the first two years in an easily accessible place.
124

123
Proposed rule 2a-5(b)(3).

124
Proposed rule 2a-5(b)(3).

As discussed above, funds must create and retain certain documentation, including the reports that advisers make to the fund board.
125

Further, we believe that a clear identification of the investments or investment types that the board has assigned to the adviser would facilitate the board's oversight of the adviser's fair value determinations.
126

These proposed recordkeeping requirements are designed to achieve these objectives and to facilitate compliance, and related regulatory oversight, with the proposed rule.

125

See supra
section II.A.6.

126
Proposed rule 2a-5(b)(3).

We request comment on these proposed additional recordkeeping requirements.

46. Are there any additional types of records that we should require the fund to maintain in connection with the assignment process? Why or why not?

47. Should we apply any or all of the proposed recordkeeping requirements of this section to the adviser, rather than the fund? If so, which requirements?

48. Are the holding periods sufficient to evidence compliance? Why or why not? Should they be different (
e.g.,
six years)?

C. Readily Available Market Quotations

The board's role in the valuation of a portfolio holding for purposes of fair value depends on whether or not market quotations are readily available for such a holding. Under section 2(a)(41) of the Investment Company Act, if a market quotation is readily available for a portfolio holding, it must be valued at the market value. Conversely, if market quotations are “not readily available,” the holding's value must be fair value as determined in good faith by the board.
127

127
Section 2(a)(41).

Neither the Investment Company Act nor the rules thereunder currently define “readily available.” However, we understand that industry practice has developed to i

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-08854. Public record. Not legal advice.