Good Faith Determinations of Fair Value

Federal RegisterJan 6, 2021

Ask Donna

What actually matters in this document.

Text

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 270

[Release No. IC-34128; File No. S7-07-20]

RIN 3235-AM71

Good Faith Determinations of Fair Value

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is adopting a new rule under the Investment Company Act of 1940 (“Investment Company Act” or the “Act”) that will 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 (“fund”). The rule will provide requirements for determining fair value in good faith for purposes of the Act. This determination will involve assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; and overseeing and evaluating any pricing services used. The rule will permit a fund's board of directors to designate certain parties to perform the fair value determinations, who will then carry out these functions for some or all of the fund's investments. This designation will be subject to board oversight and certain reporting and other requirements designed to facilitate the board's ability effectively to oversee this party's fair value determinations. The rule will 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 rule will also define when market quotations are readily available under the Act. The Commission is also adopting a separate rule providing the recordkeeping requirements that will be associated with fair value determinations and is rescinding previously issued guidance on the role of the board of directors in determining fair value and the accounting and auditing of fund investments.

DATES:

Effective date:

This rule is effective March 8, 2021.

Compliance dates:

The applicable compliance dates are discussed in section II.G of this rule.

FOR FURTHER INFORMATION CONTACT:

Zeena Abdul-Rahman, Senior Counsel; 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 at (202) 551-6918 or

IM-CAO@sec.gov,

Chief Accountant's Office, Division of Investment Management, Securities and Exchange Commission; or Jeffrey Nick or Natalie Martin, 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 adopting 17 CFR 270.2a-5 (new rule 2a-5) and 17 CFR 270.31a-4 (new rule 31a-4) 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. Periodically Assess and Manage Valuation Risks

2. Establish and Apply Fair Value Methodologies

3. Test Fair Value Methodologies for Appropriateness and Accuracy

4. Pricing Services

5. Fair Value Policies and Procedures

B. Performance of Fair Value Determinations

1. Board Oversight

2. Board Reporting

3. Specification of Functions

C. Recordkeeping

D. Readily Available Market Quotations

E. Rescission of Prior Commission Releases

F. Existing Commission Guidance, Staff No-Action Letters, and Other Staff Guidance

G. Transition Period

H. Other Matters

III. Economic Analysis

A. Introduction

B. Economic Baseline

1. Current Regulatory Framework

2. Current Practices

3. Affected Parties

C. General Economic Considerations

1. Investment Adviser Role in Fair Value Determinations

2. Board Considerations When Designating Fair Value Determinations

3. General Discussion of Benefits and Costs of Good Faith Determinations of Fair Value

D. Benefits and Costs

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

2. Performance of Fair Value Determinations

3. Recordkeeping

4. Readily Available Market Quotations

5. Rescission of Prior Commission Releases and Guidance

6. Cost Estimates

7. Other Cost Considerations and Comments on Costs

E. Effects on Efficiency, Competition, and Capital Formation

F. Reasonable Alternatives

1. Designation to Officers of Internally Managed Fund Not Permitted

2. Safe Harbor

3. Three-Tiered Approach

4. More Principles-Based Approach

5. Designation of the Performance of Fair Value Determinations to Service Providers Other Than Advisers, Officers, Trustees, or Depositors

6. Not Permit Boards To Designate a Valuation Designee

IV. Paperwork Reduction Act

A. Introduction

B. Rule 2a-5

C. Rule 31a-4

D. Rule 38a-1

V. Final Regulatory Flexibility Analysis

A. Need for the Rules

B. Significant Issues Raised by Public Comments

C. Small Entities Subject to the Rule

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Recordkeeping

2. Board Reporting

E. Agency Action To Minimize Effect on Small Entities

VI. Update to Codification of Financial Reporting Policies 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 are “readily available,” and, when a market quotation for a portfolio security is not readily available or if the investment is not a security, by using the investment's fair value, as determined in good faith by the fund's board.

Proper valuation, among other things, promotes the purchase and sale

of fund shares at fair prices, and helps to avoid dilution of shareholder interests.

Improper valuation can cause investors to pay fees that are too high or to base their investment decisions on inaccurate information.

We are adopting new 17 CFR 270.2a-5 (“rule 2a-5” or “final rule”) in response to the developments in markets and fund investment practices since the Commission last comprehensively addressed valuation 50 years ago. These include developments in the accounting and auditing literature,

the growing complexity of valuation, and intervening regulatory developments such as the development of ASC Topic 820 and the interplay of 17 CFR 270.38a-1 (“rule 38a-1” or “the compliance rule”) in facilitating board oversight of funds and the valuation process.

In addition, 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.

For example, funds that invest primarily in fixed income instruments (which may require fair value determinations for some or all of the portfolio assets) have expanded from around $800 billion in assets to over $4.5 trillion in just the last 20 years.

Section 2(a)(41) of the Investment Company Act.

See also

17 CFR 270.2a-4 (“rule 2a-4”). 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. 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 this 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 rescission of the accounting guidance.

See

Good Faith Determinations of Fair Value, Investment Company Act Release No. 33845 (Apr. 21, 2020) [85 FR 28734 (May 13, 2020)] (“Proposing Release”), at n.2.

See Id.

at nn.1-11 and accompanying text.

See

Securities and Exchange Commission Codification of Financial Reporting Policies, Statement Regarding “Restricted Securities,” Investment Company Act Release No. 5847 (Oct. 21, 1969) [35 FR 19989 (Dec. 31, 1970)], Financial Reporting Codification (CCH) section 404.04 (Apr. 15, 1982) (“ASR 113”); Investment Companies, Investment Company Act Release No. 6295 (Dec. 23, 1970) [35 FR 19986 (Dec. 31, 1970)], Financial Reporting Codification (CCH) section 404.03 (Apr. 15, 1982) (“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.

See

Proposing Release,

supra

footnote 2, at nn.17-31 and accompanying text.

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 (Nov. 25, 2019) [85 FR 4446 (Jan. 24, 2020)] (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) [76 FR 55237 (Sept. 7, 2011)], at 69 (noting that “[v]aluation of some derivatives may present special challenges for funds”);

see also

Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 34084 (Nov. 2, 2020) [85 FR 83162 (Dec. 21, 2020)] (“Derivatives Adopting Release”) at n.1 and accompanying text. 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 September 11, 2020, there were 12,680 open-end funds registered with the Commission with total net assets of over $27 trillion.

See infra

footnotes 496 through 497 and accompanying text. Moreover, as of September 2020, there were 97 business development companies (“BDCs”) with $62 billion in total net assets.

See infra

footnote 497 and accompanying text. BDCs, which did not exist in 1970, must invest at least 70% of their assets in certain investments, which may be difficult to value.

See

section 55(a) of the Act.

See

2020 Investment Company Institute Fact Book at data table 3

available at https://www.icifactbook.org/data/20_fb_data.

See also

Proposing Release,

supra

footnote 2 (discussing the fund industry changes since the issuance of ASR 113 and 118).

We proposed rule 2a-5 in April 2020 and received more than 60 comment letters on the proposal.

Most commenters supported the Commission's goal of modernizing the regulatory framework for fund valuations.

Commenters generally agreed that the proposed framework for making a fair value determination was reasonable and consistent with current practice, but several requested additional flexibility regarding certain proposed requirements.

See

Proposing Release,

supra

footnote 2. The comment letters on the Proposing Release (File No. S7-07-20) are available at

https://www.sec.gov/comments/s7-07-20/s70720.htm.

See, e.g.,

Comment Letter of Fidelity Investments (July 21, 2020) (“Fidelity Comment Letter”); Comment Letter of the American Bar Association (July 20, 2020) (“ABA Comment Letter”); Comment Letter of Franklin Resources, Inc. (July 21, 2020) (“Franklin Comment Letter”); Comment Letter of Charles E. Andrews, James G. Ellis, Pablo R. González Guajardo, Vanessa C.L. Chang, John G. Freund, and Christopher E. Stone (July 21, 2020) (“American Fund Trustees Comment Letter”); Comment Letter of the New York City Bar Association (July 21, 2020) (“NYC Bar Comment Letter”). However, some commenters objected to the proposal.

See

Comment Letter of Douglas Scheidt (May 29, 2020) (“Scheidt Comment Letter 1”) and (June 29, 2020) (“Scheidt Comment Letter 2”); Comment Letter of Michael Cohan, David Jessup, Jr., and Shenghang Jiang (July 21, 2020) (“University of Miami Comment Letter”).

See, e.g.,

Comment Letter of J.P. Morgan Asset Management (July 15, 2020) (“JPMAM Comment Letter”); Comment Letter of the Vanguard Group (July 21, 2020) (“Vanguard Comment Letter”); Comment Letter of the Investment Company Institute (July 16, 2020) (“ICI Comment Letter”); Comment Letter of the Asset Management Group of the Securities Industry and Financial Markets Association (July 21, 2020) (“SIFMA AMG Comment Letter”); Comment Letter of Capital Research and Management Company (July 21, 2020) (“Capital Group Comment Letter”).

We are adopting rule 2a-5 and companion 17 CFR 270.31a-4 (“rule 31a-4” and, together with rule 2a-5, the “rules”) with certain modifications from the proposal to address the comments we received, including targeted revisions to address issues noted with respect to certain of the more prescriptive elements of the proposed rule. We are also rescinding the Commission's previously issued guidance on the role of the board of directors in determining fair value and the accounting and auditing of fund investments as proposed and, in a change from the proposal, are superseding certain of the guidance on thinly traded securities and the use of pricing services the Commission issued in 2014.

Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 47736 (Aug. 14, 2014)] (“2014 Money Market Fund Release”).

II. Discussion

The final rule provides 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.

We believe that, in light of the developments discussed above and in the Proposing Release, 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 the final rule establishes.

The final rule defines a “fund” as a registered investment company or a business development company. Rule 2a-5(e)(1).

One commenter stated that rule 2a-5 does not require the Commission to exercise its exemptive authority under section 6(c). Comment Letter of Jack Murphy (July 20, 2020) (“Murphy Comment Letter”). We agree and are relying on our authority under other provisions of the Investment Company Act, including our authority under section 38(a) of the Act, to adopt rule 2a-5. In any event, we believe the final rule's provisions are necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the Act. Accordingly, we believe section 6(c) also provides additional authority for the final rule.

Under the final rule, fair value as determined in good faith will require assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; and overseeing and evaluating any pricing services used. 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.

The final rule also permits a fund's board

to designate a “valuation designee” to perform fair value determinations.

The valuation

designee can be the adviser of the fund or, in a change from the proposal, an officer of an internally managed fund.

When a board designates the performance of determinations of fair value to a valuation designee for some or all of the fund's investments under the final rule, the final rule requires the board to oversee the valuation designee's performance of fair value determinations. To facilitate such oversight, the final rule also includes certain reporting and other requirements.

The final rule acknowledges that, consistent with longstanding practice, these valuation designees often play an important and valuable role in carrying out the day-to-day work of determining fair values. Under the final rule, the board remains responsible for the fair value determinations required by the statute. Where the board designates a valuation designee to perform fair value determinations under the final rule, the board will fulfill its continuing statutory obligations through active oversight of the valuation designee's performance of fair value determinations and compliance with the other requirements of the final rule.

For purpose of the final 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. Rule 2a-5(e)(3).

See infra

footnotes 138-140 and accompanying text (discussing the change from the proposed “assign” to the term “designate” in the final rule).

Rule 2a-5(e)(4).

Rule 2a-5(b).

One commenter stated his belief that the Commission would need to use exemptive authority to “shift[ ] the statutory fair valuation responsibilities” away from fund directors. Scheidt Comment Letter 2.

But see

Murphy Comment Letter. As discussed above, we emphasize that the final rule does not in fact shift the statutory fair valuation responsibilities away from directors. Rather, the final rule establishes the requirements the board must meet to fulfill its continuing statutory obligations.

Also, as proposed, the final rule applies to all registered investment companies and BDCs, regardless of their classification or sub-classification (

e.g.,

open-end funds and closed-end funds),

or their investment objectives or strategies (

e.g.,

equity or fixed income; actively managed or tracking an index).

In the case of a unit investment trust (“UIT”), because a UIT does not have a board of directors or adviser, a UIT's trustee, or, in a change from the proposal, the UIT's depositor must conduct fair value determinations under the final rule.

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.

See

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

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 (Mar. 9, 1987) [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.E (rescission of staff guidance).

While many commenters thought that the proposal's general approach of balancing between prescriptive requirements and principles-based guidelines was reasonable, others requested modifications.

A number of commenters recommended that the Commission recast the proposed rule as a non-exclusive safe harbor or provide additional flexibility.

Some stated that they believed that fair value in good faith is a flexible concept, and thus they believed that fair value determinations are not amenable to a single approach, which they believed was consistent with the flexible approach taken in ASR 118.

See, e.g.,

JPMAM Comment Letter; Vanguard Comment Letter; Comment Letter of State Street Global Advisors (July 21, 2020) (“SSGA Comment Letter”); Comment Letter of Baillie Gifford Funds (July 21, 2020) (“Baillie Gifford Comment Letter”).

See, e.g.,

Comment Letter of Arthur E. Johnson, Chairman of Independent Trustees, Fidelity Fixed Income and Asset Allocation Funds and David M. Thomas, Co-Lead Independent Trustee, Fidelity Equity and High Income Funds (June 26, 2020) (“Fidelity Trustees Comment Letter”); ICI Comment Letter; Comment Letter of Ronald E. Toupin, Board Chair, Guggenheim Funds (July 20, 2020) (“Guggenheim Trustees Comment Letter”); Catherine L. Newell, General Counsel and Executive Vice President, Dimensional Fund Advisers (July 27, 2020) (“Dimensional Comment Letter”); Comment Letter of Dechert LLP (July 21, 2020) (“Dechert Comment Letter”); Comment Letter of David B. Smith, General Counsel, Mutual Fund Directors Forum (July 21, 2020) (“MFDF Comment Letter”).

See

ICI Comment Letter; Fidelity Trustees Comment Letter; Guggenheim Trustees Comment Letter; Dimensional Comment Letter; Dechert Comment Letter.

See also

ASR 118 and Letter to Craig S. Tyle, General Counsel, Investment Company Institute (Dec. 8, 1999) and

infra

footnote 386 and accompanying text.

In light of the developments since the Commission last comprehensively addressed fair value determinations for funds, we believe that it is important to establish a minimum and consistent framework for fair value practices across funds. This framework also allows the Commission to articulate appropriate oversight measures, as outlined in section II.B below,

that are designed to help address valuation risks, including those arising from conflicts of interest.

The final rule establishes minimum and baseline standards that we believe are inherent in any good faith fair value determination, as informed by current industry practice. If we were to establish a safe harbor, in contrast, it may give the misleading impression that an approach to making fair value determinations that does not meet this minimum baseline would satisfy the board's statutory obligations.

The final rule does not establish a single approach to making such determinations. Instead, it establishes a principles-based framework for boards to use in creating their own specific process for making fair value determinations, including through designating and appropriately overseeing a valuation designee to perform certain valuation tasks.

It reflects an appropriate balance between providing a board or valuation designee with the flexibility to exercise judgment in the valuation process consistent with its good faith, paired with an appropriate set of baseline standards. Accordingly, we do not think that it is appropriate to recast rule 2a-5 as a safe harbor. However, we do agree with commenters that additional flexibility is appropriate in certain areas and have made a number of changes from the proposal in this regard, as discussed below.

Throughout this release, when we refer to “appropriate” oversight, we mean oversight consistent with the guidance set out

infra

in section II.B.1.

As stated in the Proposing Release, 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 final rule.

See

Proposing Release,

supra

footnote 2, at 14-15.

We do not believe that establishing a baseline for making fair value determinations detracts from, or is at odds with, the board's fiduciary duty. Nothing in this rulemaking should be construed as abrogating or limiting any of the fiduciary duties that boards owe to funds.

See, e.g.,

section 36(a) of the Act;

Burks

Lasker,

441 U.S. 471, 484-85 (1970).

See also

Fidelity Comment Letter (approving of the proposed approach of describing the process that must be followed rather than the describing with specificity the substantive elements of a proper fair value determination); ICI Comment Letter (appreciating that the Commission has not prescribed detailed methodological or investment-specific valuation guidance and instead emphasized process, reporting, and oversight).

See, e.g.,

infra

section II.B.2.

In support of a safe-harbor approach, some commenters raised concerns that violations of the proposed rule that may not directly impact the value given to an asset, for example a failure to keep records for the prescribed period, could

raise doubts about whether a valuation was made consistent with the requirements of the Act. These commenters stated that this would be true even where the end result of the actual valuation was appropriate.

In response to these concerns, as discussed below, we are tailoring certain of the proposed reporting requirements and moving the proposed recordkeeping requirements out of rule 2a-5 and into a separate rule under the Act.

While a board or adviser's failure to comply with the final rule's requirements may call into question the effectiveness of the fund's fair value process and its compliance program, the Commission underscores that the objective of the final rule is to ensure that a fund's assets are properly valued. A violation of the final rule does not necessarily mean that the actual values ascribed to particular fund investments were in fact inappropriate, or, for example, that the fund has violated rule 22c-1.

See, e.g.,

Comment Letter of Stradley Ronon Stevens Young, LLP (July 21, 2020) (“Stradley Comment Letter”); Comment Letter of Guggenheim Investments (July 21, 2020) (“Guggenheim Comment Letter”); Dechert Comment Letter.

See infra

section II.C.

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

Rule 2a-5 sets forth certain required functions that must be performed to determine the fair value of the fund's investments in good faith.

As discussed below, we are adopting these required functions substantially as proposed, with several changes from the proposal based on the comments the Commission received.

As proposed, these requirements will apply to a fund's board that is determining fair value or, if the board designates a valuation designee to perform any fair value determinations as discussed below, to that party.

1. Periodically Assess and Manage Valuation Risks

We are adopting, as proposed, the requirement to assess periodically any material risks associated with the determination of the fair value of the fund's investments, including material conflicts of interest, and to manage those identified valuation risks.

Also as proposed, the final rule does not identify other specific valuation risks that may need to be addressed under this requirement or establish a specific re-assessment frequency.

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.

Several commenters expressed general support for the valuation risk requirement,

with others suggesting certain modifications, particularly regarding whether the final rule should prescribe a frequency for the proposed periodic re-assessment of the fund's material valuation risks.

One commenter opposed the proposed requirement entirely, and suggested that the Commission remove references to valuation risk from the proposed rule, on the basis that identified valuation risks should have no impact on the actual fair valuing of particular fund investments, and that this requirement thus would unnecessarily complicate the final rule while providing no investor protection benefit.

See

Comment Letter of Valuation Research Corporation (July 21, 2020) (“VRC Comment Letter”); Murphy Comment Letter.

See, e.g.,

Comment Letter of Sullivan & Worcester LLP (June 8, 2020) (“Sullivan Comment Letter”) (suggesting requirement of annual re-assessment of valuation risks); Comment Letter of the International Valuation Standard Council (July 14, 2020) (“IVSC Comment Letter”) (same);

but see

ABA Comment Letter (stating that valuation policies and procedures, including procedures for re-assessment of valuation risks, would be subject to annual review under rule 38a-1, and recommending no minimum frequency in final rule).

See

Franklin Comment Letter. For the same reasons, this commenter also suggested that we remove the proposed requirement that the adviser periodically report to the board on material changes to the assessment and management of valuation risks, including conflicts of interest. As discussed in section II.B.2.a below, the final rule includes periodic reporting on material changes in the assessment and management of valuation risks.

After considering these comments, we continue to believe that requiring the assessment and management of material valuation risks in the final rule will help promote an effective overall process for fair valuing fund investments in good faith.

With respect to the frequency of the required periodic re-assessment of valuation risks, we continue to believe that different frequencies for the re-assessment of valuation risks may be appropriate for different funds or risks, and have determined not to modify the proposed rule to include a required minimum frequency. We also continue to believe, as stated in the Proposing Release, 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.

The final rule will require, among other things, that the board or valuation designee, as applicable, take into account the fund's valuation risks in establishing and applying fair value methodologies and, where the board has designated the valuation designee to perform fair value determinations, periodic reporting on material changes in the management and assessment of valuation risks, as discussed in section II.B.2.a) below.

See

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

See

Proposing Release,

supra

footnote 2, at section II.A.1.

The Proposing Release also included a non-exhaustive list of examples of sources or types of valuation risk.

As discussed below, we are reiterating this non-exhaustive list here, with several modifications to broaden the examples to include additional sources and types of risk raised by commenters.

See id.

We received a number of comments on the list of sources and types of valuation risk. One commenter expressed general support for the inclusion of this list, including its level of generality in describing sources and types of risk.

One commenter, on the other hand, stated that this list would cause confusion because funds cannot anticipate how the identified sources and types of valuation risk will affect the valuation of particular investments.

One commenter stated that the text of the final rule should identify specific valuation risks (similar to the non-exhaustive list discussed in the Proposing Release) that a board or adviser, as applicable, must assess and manage.

Other commenters recommended that the Commission identify additional sources and types of valuation risks.

See, e.g.,

Murphy Comment Letter.

See

Franklin Comment Letter (questioning whether funds should be expected to anticipate “potential market shocks or dislocations” in fair valuing their investments).

See also

ABA Comment Letter (stating that a board or adviser's assessment of valuation risks cannot account for potential future events, such as potential market shocks or dislocations that could change the assessment or management of valuation risk).

See

University of Miami Comment Letter.

See, e.g.,

Comment Letter of IHS Markit (July 21, 2020) (“IHS Markit Comment Letter”) (stating that additional risks include the market structure for the asset); Murphy Comment Letter (stating that additional risks include the possibility that an adviser or third-party service provider will be unable to operate).

One commenter recommended we clarify that the assessment and management of valuation risks other than those identified in the Proposing Release can satisfy this requirement.

Similarly, one commenter suggested we clarify that some sources or types of valuation risk may be considered more or less important than others based on a particular fund's investments, the markets in which its investments trade, reliance on third-party service providers, and other relevant circumstances.

See

Stradley Comment Letter.

See

ABA Comment Letter.

After considering these comments, we continue to believe that a fund's specific

valuation risks depend on the facts and circumstances of the particular fund's investments. As such, we believe that the non-exhaustive list of examples of sources and types of valuation risk, set forth below, is appropriate. As we stated in the Proposing Release, the risks identified are not intended to be a comprehensive list of all possible sources of valuation risk, but a set of examples that may help inform fund boards and valuation designees. We agree that the additional risks identified by commenters may also be relevant for certain funds, and have broadened the list provided below in several respects to include those risks. The final rule, like the proposal, is designed to provide a board or valuation designee, as applicable, with the flexibility to determine which of the identified sources and types of valuation risk are relevant to the fund's investments, as well as to identify other risks not listed here. The final rule also provides flexibility to determine whether certain sources and types of valuation risk should be weighed more heavily than others.

As such, the following is a non-exhaustive list of sources or types of valuation risk:

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

and the characteristics of those investments;

We recognize that in assessing and managing this potential source of valuation risk, a board or valuation designee, as applicable, may not be able to identify all of the types of investments the fund will hold or the specific valuation risks related to such investments. This risk assessment and management generally should take into account those investments that the fund reasonably expects to purchase in the reasonably near term.

Investment characteristics would include among other things, the size of the investment relative to measures of market demand, such as daily trading volume.

• Potential market or sector shocks or dislocations and other types of disruptions that may affect a valuation designee's or a third-party's ability to operate;

Indicators of potential 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. Additional types of disruptions that may affect a valuation designee's or a third-party's ability to operate include, for example, a system failure or cyberattack.

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

See infra

footnotes 354-355 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.

2. Establish and Apply Fair Value Methodologies

As proposed, the final rule will provide that fair value as determined in good faith requires the board or valuation designee, as applicable, to establish and apply fair value methodologies. To satisfy this requirement, a board or valuation designee, as applicable, must:

(1) Select and apply appropriate fair value methodologies;

(2) Periodically review the appropriateness and accuracy of the methodologies selected and make any necessary changes or adjustments thereto; and

(3) Monitor for circumstances that may necessitate the use of fair value.

As discussed below, we are adopting these functions substantially as proposed, with certain modifications to respond to commenters' concerns and suggestions.

(a) Select and Apply Appropriate Fair Value Methodologies

The final rule will require the board or valuation designee, as applicable, to select and apply in a consistent manner an appropriate methodology or methodologies

for determining (which includes calculating) the fair value of fund investments.

As proposed, to satisfy this requirement, the board or valuation designee, as applicable, will have to specify the key inputs and assumptions specific to each asset class or portfolio holding.

We are, however, modifying the requirement to select and apply appropriate methodologies in the final rule in two ways to address commenter concerns and suggestions. First, the final rule will provide that the selected methodologies for fund investments may be changed if different methodologies are equally or more representative of the fair value of the investments. Second, the final rule will not require the specification of methodologies that will apply to new types of investments in which the fund intends to invest.

As the Commission stated in the Proposing Release, 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 Adopting 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.

Proposing Release,

supra

footnote 2, at n.45 and accompanying text. As stated in the Proposing Release, 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).

See

rule 2a-5(a)(2)(i).

We received numerous comments on the proposed requirement that the board or adviser, as applicable, select and apply in a consistent manner an appropriate methodology or methodologies for determining (which includes calculating) the fair value of fund investments. These commenters generally requested clarification relating to the proposed requirement that a board or adviser, as applicable, select and apply fair value methodologies “in a consistent manner.” Several commenters stated that this proposed requirement suggested that a board or adviser, as applicable, generally may select only one methodology per asset class, and requested we clarify that this requirement does not preclude a board or adviser, as applicable, from selecting different methodologies for different securities within the same asset class or sub-class.

The final rule clarifies that this requirement is not meant to limit a board or valuation designee, as applicable, from using an appropriate methodology to fair value an investment, even if other investments within the same “asset class” are fair valued using a different appropriate methodology.

See, e.g.,

ICI Comment Letter; Sullivan Comment Letter; Murphy Comment Letter; Comment Letter of MFS Investment Management (July 21, 2020) (“MFS Comment Letter”); Comment Letter of John Hancock Investment Management LLC (July 21, 2020) (“John Hancock Comment Letter”).

Similarly, commenters requested we clarify that the requirement to select and apply fair value methodologies in a consistent manner does not restrict a board's or adviser's ability to change the selected methodology for an investment or asset class under appropriate circumstances.

We recognize that

there may be circumstances where it is appropriate to change a methodology if it would result in a measurement that is equally or more representative of fair value.

Accordingly, we have modified the final rule to clarify that the requirement to apply fair value methodologies in a consistent manner does not preclude the board or valuation designee, as applicable, from changing the methodology for an investment in such circumstances.

Applying a methodology consistently is not meant to lock in place a rigid pre-established methodology, but instead to address the risks associated with switching methodologies in order to achieve a specific outcome. Accordingly, the consistent application of appropriate methodologies allows for a board or valuation designee, as applicable, to select and apply a different methodology or methodologies for investments in the same asset class, or to change the methodology selected for one or more particular investments, based on changes to the facts and circumstances related to the particular investment if different methodologies are equally or more representative of the fair value of the investments.

Any change in methodology must be documented under the applicable recordkeeping requirements.

See, e.g.,

Sullivan Comment Letter; IVSC Comment Letter; JPMAM Comment Letter;

Comment Letter of Seward & Kissel LLP (July 20, 2020) (“Seward & Kissel Comment Letter”). For this reason, two commenters also suggested that we remove this term from the final rule.

See

Franklin Comment Letter; Comment Letter of Federated Hermes, Inc. (July 21, 2020) (“Federated Hermes Comment Letter”).

See

ASC Topic 820-10-35-25 (requiring consistent application of valuation techniques, but providing that a change in a valuation technique or its application is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances).

See

rule 2a-5(a)(2)(i).

A change includes using a new methodology or making a material adjustment to an existing methodology.

See

JPMAM Comment Letter.

See

rule 31a-4(a). Furthermore, where the board has designated the valuation designee to perform fair value determinations, the final rule will require that the valuation designee periodically report to the board on material changes to, or material deviations from, the fair value methodologies established under this requirement.

See

rule 2a-5(b)(1)(i)(A)(

)(

Commenters questioned our statement in the Proposing Release that to be appropriate under rule 2a-5, a methodology used for purposes of determining fair value must be consistent with ASC Topic 820,

and thus must be derived from one of the principles-based approaches described therein.

Some of these commenters suggested that ASC Topic 820 is not appropriately tailored to address all of the specific circumstances that may arise for a fund that values its assets daily, and stated that we should either provide more specific guidance for certain funds or investments,

or not limit appropriate methodologies to those addressed in ASC Topic 820.

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.

See supra

footnote 50.

See, e.g.,

NYC Bar Comment Letter; Scheidt Comment Letter 2.

See

Scheidt Comment Letter 2.

See

ABA Comment Letter.

We believe that an appropriate methodology must be consistent with those used to prepare the fund's financial statements and thus be consistent with the principles of the valuation approaches laid out in ASC Topic 820. Therefore, if a valuation methodology was used that is not consistent with the principles of the valuation approaches laid out in ASC Topic 820, we would presume that use of such a methodology would be misleading or inaccurate. While the valuation approaches laid out in ASC Topic 820 may not directly address every situation that a fund may face because the accounting standards are principles-based, we believe that taking a valuation approach that is inconsistent with the principles outlined in ASC Topic 820 may result in a fund having a misleading or inaccurate fair value process because such an approach may not be consistent with U.S. GAAP and the fund's financial reporting process. Supplemental methodologies for situations not explicitly outlined in ASC Topic 820 may be appropriately applied by boards or valuation designees provided that the methodologies are not inconsistent with the principles outlined in ASC Topic 820. We recognize 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.

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. A consistent application of the selected methodology or methodologies, with changes to the methodology or methodologies where appropriate, together with the other provisions of the rules, would promote unbiased determinations of fair value within the range.

This is consistent with what the Commission previously said in 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, the methodologies selected should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.

Commenters suggested we clarify that certain guidance provided in the 2014 Money Market Funds Adopting Release relating to the valuation of thinly traded securities is being superseded by final rule 2a-5 and the related guidance provided herein.

We believe that the guidance contained in this section addresses the same concerns discussed in the guidance contained in the last paragraph of the section on valuing thinly traded securities in the 2014 Money Market Funds Adopting Release.

Accordingly, that paragraph is superseded. As a general principle, determining fair value requires taking into account market conditions existing at the time of the determination. Accordingly, appropriate methodologies for funds holding debt securities generally should not fair value these securities at par or amortized cost based on the expectation that the funds will hold those securities until maturity, if the funds could not reasonably expect to receive approximately that value upon the measurement date under current market conditions. We continue to believe that fair value cannot be based on what a buyer might pay at some later time, such as when the market ultimately recognizes the security's true value as currently perceived by the portfolio manager.

Funds also may not fair value portfolio securities at prices not achievable on a current basis on the belief that the fund would not currently need to sell those securities. We believe the principles established in ASC Topic 820, which provide that an investment is valued based on an exit price at the measurement date from the perspective of a market participant under current market conditions, are consistent with the statements in this paragraph.

See, e.g.,

Vanguard Comment Letter.

See

2014 Money Market Funds Release,

supra

footnote 11, at last paragraph of section III.D.2.a.

See

2014 Money Market Funds Release,

supra

footnote 11, at section III.D.2.a.

See

ASC 820-10-35-3 and ASC 820-10-20 (“A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.”; Fair Value means “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement

date”).

See also

ASC Topic 820, at par. 820-10-35-54H (“A reporting entity's intention to hold the asset or to settle or otherwise fulfill the liability is not relevant when measuring fair value because fair value is a market-based measurement, not an entity-specific measurement.”).

The proposed rule also would have required the board or adviser, as applicable, to 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.

This requirement was designed to facilitate the effective determination of the fair value of these new investments by the board or adviser, as applicable. While one commenter suggested that this requirement was appropriate as proposed,

other commenters generally opposed this requirement as being potentially overly burdensome by requiring boards and advisers to establish a predetermined list of methodologies to account for

all

types of new investments in which the fund may invest.

Proposed rule 2a-5(a)(2)(i)(B).

See

IHS Markit Comment Letter (stating that funds currently have processes in place to ensure that a methodology and supporting pricing service provider are in place to cover new investments).

See, e.g.,

Sullivan Comment Letter; Seward & Kissel Comment Letter; ABA Comment Letter; VRC Comment Letter.

We are persuaded that specifically requiring a predetermination of the methodologies that must be applied to hypothetical future investments could cause undue burdens to the extent it caused a fund to establish methodologies for assets in which a fund ultimately does not invest. Moreover, a fund will be required to value all of its investments, regardless of whether the fund had pre-determined a methodology. We believe that the general requirement under the final rule to select and apply in a consistent manner an appropriate methodology or methodologies for determining (and calculating) the fair value of fund investments,

will require a board or a valuation designee, where applicable, to determine which methodology is appropriate for a new investment type that a fund has actually purchased by the time the investments are valued. Accordingly, we have determined to remove from the final rule the proposed specific requirement that a board or adviser, as applicable, specify in advance the fair value methodologies that will apply to new types of investments in which the fund intends to invest.

See

rule 2a-5(a)(1).

(b) Periodically Review the Appropriateness and Accuracy of the Methodologies Selected

To establish and apply fair value methodologies appropriately, the final rule will require a board or valuation designee to review periodically the selected fair value methodologies for appropriateness and accuracy, and to make changes or adjustments to the methodologies where necessary.

We are adopting this requirement substantially as proposed, with one modification, discussed below, to respond to a comment we received. In addition, as stated in the Proposing Release, the results of back-testing or calibration (as discussed below) or a change in circumstances specific to an investment, for example, could necessitate adjustments to a fund's fair value methodologies.

See

Proposing Release,

supra

footnote 2, at n.50 and accompanying text.

Cf.

ASC Topic 820-10-35-25, which 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 valuation designees generally should seek to account for such occurrences and consider specifying alternative sources.

We received one comment on this requirement. The commenter generally supported it, but suggested we clarify that “adjustments” to the selected fair value methodologies under this requirement may include a change to new appropriate methodologies.

We agree, and have added the word “change” to the final rule to clarify that a necessary adjustment to the selected methodology under the final rule is not limited to modifying an existing methodology for a particular investment (for example, adjusting inputs), but also may include changing to a new methodology where appropriate.

See

Murphy Comment Letter.

See supra

section II.A.2.a).

As proposed, the final rule will also require the board or valuation designee, as applicable, to monitor for circumstances that may necessitate the use of fair value as determined in good faith.

For example, if a fund invests in securities that trade in foreign markets, the board or valuation designee, as applicable, 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.

Rule 2a-5(a)(2)(iii).

Cf.

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

One commenter generally requested we clarify that this requirement is not meant to require the board or valuation designee, where applicable, to identify in advance

all

of the circumstances that may require the use of fair value.

While we agree that the circumstances that may necessitate fair value depend on the facts and circumstances of the particular fund's investments and that certain of these circumstances cannot be established in advance, we also believe that monitoring for circumstances that may require the use of fair value is an important element of an effective overall process for determining fair value in good faith.

See

John Hancock Comment Letter.

The proposed rule also would have required the establishment of criteria for determining when market quotations are no longer reliable and therefore not readily available.

One commenter viewed this proposed requirement as potentially being overly restrictive of boards' and advisers' discretion to question the reliability of market quotations, and suggested we remove it from the final rule.

Another commenter suggested that requiring a board or adviser to identify in advance all of the criteria indicating when a market quotation may not be reliable would be overly burdensome.

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

See

Sullivan Comment Letter.

See

John Hancock Comment Letter.

Although this requirement derived from the Commission's positions under the compliance rule,

we have determined to remove it from the final rule. We agree with commenters that requiring, in advance, a list of specific

criteria

for determining when market quotations may no longer be reliable could limit the board's or valuation designee's flexibility to consider the full range of conditions that may affect the reliability of market quotations. In addition, we believe that to satisfy the requirement to monitor for circumstances that may necessitate the use of fair value, discussed above, boards and valuation designees would have to take into account the circumstances that may cause market quotations to be no longer reliable. The final rule, however, will not require

those broader circumstances to be captured in specific criteria.

See

Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR 74713 (Dec. 24, 2003)] (“Compliance Rules Adopting Release”).

3. Test Fair Value Methodologies for Appropriateness and Accuracy

As proposed, the final rule will require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value.

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. The final rule, similar to the proposal, will require the board or valuation designee, as applicable, to identify the testing methods to be used and the minimum frequency with which such testing methods are used, but will not require particular testing methods or a specific minimum frequency for the testing.

Rule 2a-5(a)(3).

While several commenters supported the proposed requirement,

other commenters recommended that we modify or clarify the requirement in the final rule. One commenter recommended that we remove from the final rule the proposed requirement that the adviser or board identify the testing methods to be used and the minimum frequency with which such testing methods are used, viewing it as overly prescriptive and too limiting of the discretion of the board or adviser, as applicable, to determine how testing should be conducted.

Several commenters recommended we clarify that parties other than the board or adviser, as applicable, such as pricing services, may perform the testing.

One commenter asked that we provide a de minimis exception to the proposed testing requirement for funds that have a limited amount of fair valued investments.

Finally, one commenter recommended that the final rule require that methodology testing be performed at least quarterly or whenever the fund provides financial statements to investors.

See, e.g.,

Baillie Gifford Comment Letter; Capital Group Comment Letter; Comment Letter of Invesco Advisers, Inc. (July 21, 2020) (“Invesco Comment Letter”).

See

Franklin Comment Letter.

See

ICI Comment Letter; IHS Markit Comment Letter; Comment Letter of New York State Society of Certified Public Accountants (Jul. 22, 2020) (“NYSSCPA Comment Letter”). We received several comments generally requesting that we clarify that the board or adviser, where applicable, may engage third parties to assist with fair value determinations. Those comments are addressed below in section II.B relating to guidance on assistance of others.

See

NYSSCPA Comment Letter.

See

Comment Letter of CFA Institute (July 21, 2020) (“CFA Institute Comment Letter”).

After considering these comments, we continue to 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 valuation designee, as applicable. We also continue to believe that requiring the identification of (1) the testing methods to be used, and (2) the minimum frequency of the testing, is appropriate and still provides boards and valuation designees with flexibility to perform methodology testing based on the particular circumstances of a particular fund.

We believe that funds that have even a limited amount of fair valued investments should test their methodologies, and therefore are not providing a de minimis exception.

Testing can often reveal important information about the continuing appropriateness of a methodology. We expect the frequency and nature of testing would vary depending on the type and amount of investments held by the fund. If a specific methodology consistently over-values or under-values one or more fund investments as compared to observed transactions, the board or valuation designee, as applicable, should investigate the reasons for this difference.

Calibration can assist in assessing whether the fund's valuation technique reflects current market conditions, and 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.

See

Proposing Release,

supra

footnote 2, at n.57.

See

NYSSCPA Comment Letter.

Calibration and back-testing are examples of particularly useful testing methods to identify trends in certain circumstances, and potentially to assist in identifying issues with methodologies applied by fund service providers, including poor performance or potential conflicts of interest.

Several commenters recommended we clarify that this statement is not meant to suggest that calibration and back-testing are required testing methods, or that the use of appropriate testing methods other than calibration and back-testing would not satisfy the testing requirement.

While we believe that calibration and back-testing are methods that should be used for testing the appropriateness and accuracy of funds' fair value methodologies in many circumstances, the final rule does not require calibration and back-testing, nor does it preclude boards or valuation designees, where applicable, from using other appropriate testing methods.

We expect that as testing methodologies are developed and change over time, new and different tools for testing may also become more prominent or useful. The final rule provides flexibility to allow funds to use new, appropriate testing methods.

As stated in the Proposing Release, 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.

See

Proposing Release,

supra

footnote 2, at n.58.

See, e.g.,

Comment Letter of T. Rowe Price Associates, Inc. (“July 21, 2020) (“TRC Comment Letter”); SIFMA Comment Letter; CFA Institute Comment Letter.

We recognize, for example, that back-testing as a testing method may be less useful for portfolio holdings that trade infrequently.

See

Proposing Release,

supra

footnote 2, at n.59 and accompanying text.

4. Pricing Services

As proposed, the final rule will provide that determining fair value in good faith requires the oversight and evaluation of pricing services, where used.

For funds that use pricing services, the final rule will require that the board or valuation designee, as applicable, establish a process for approving, monitoring, and evaluating each pricing service provider. The final rule also will require that the board or valuation designee, as applicable, establish a process for initiating price challenges as appropriate. Commenters generally supported the proposal to require the board or adviser, as applicable, to oversee and evaluate pricing services.

One commenter, however, stated that this oversight provision is unnecessary in the case of pricing services that are not affiliated with the fund's adviser.

This commenter stated that pricing services should not be distinguished from other third-party fund service providers, which advisers oversee to meet their own fiduciary obligations. Another commenter questioned the significance

of a pricing service's conflicts of interest, stating that pricing services maintain relationships with a wide variety of investment advisers, and generally are expected to provide the same valuation information with respect to a particular security to all funds.

As a result, this commenter asserted that it would be less likely for a pricing service to be unduly pressured to provide favorable information in a particular scenario or to a particular investment adviser. We believe, however, that the conflict is not necessarily one of responding to pressure from a particular investment adviser, but, rather, a pricing service might generally provide higher or more aggressive valuations to retain business.

Rule 2a-5(a)(4).

See, e.g.

Comment Letter of Deloitte & Touche LLP (July 15, 2020) (“Deloitte Comment Letter”); Fidelity Trustees Comment Letter; John Hancock Comment Letter; ICI Comment Letter; Comment Letter of Council of Institutional Investors (July 20, 2020) (“Council of Institutional Investors Comment Letter”); Comment Letter of AIMA (July 21, 2020) (“AIMA Comment Letter); Vanguard Comment Letter; Invesco Comment Letter; MFS Comment Letter; VRC Comment Letter; Guggenheim Comment Letter; TRP Comment Letter; IVSC Comment Letter; Comment Letter of Harvest Investments, Ltd. (July 21, 2020) (“Harvest Comment Letter”); Murphy Comment Letter.

Stradley Comment Letter.

John Hancock Comment Letter.

We believe, and many commenters agreed, that pricing services play an important role in the fair value process by providing information on evaluated prices, matrix prices, price opinions, or similar pricing estimates or information that can assist in determining the fair value of fund investments.

Additionally, we believe that pricing services may have conflicts of interest such as maintaining continuing business relationships with the valuation designee. Therefore, given the widespread reliance on pricing services, the critical role they play in the valuation of fund investments, and their potential conflicts of interests, regardless of whether they are affiliated with the fund's adviser, the final rule will require that pricing services be subject to oversight so that the board or valuation designee, as applicable, has a reasonable basis to use the pricing information it receives as an input in determining fair value in good faith. To oversee pricing services effectively, the board or valuation designee, as applicable, should establish a process for the approval, monitoring, and evaluation of each pricing service provider used.

See, e.g.

Fidelity Trustees Comment Letter; Deloitte Comment Letter.

See also

Capital Group Comment Letter (noting that more than 50% of the fund portfolios with non-U.S. equity strategies may be subject to non-U.S. price adjustments due to significant U.S. market moves, which would require pricing services to provide a substantial amount of pricing information).

In a change from the proposal, we are modifying the final rule to require funds to establish a

process

for initiating price challenges as appropriate, instead of the proposed approach that would have required funds to establish

criteria

for the circumstances under which price challenges would be initiated.

Many commenters stated that requiring funds to establish specific criteria, such as objective thresholds, for price challenges was too rigid. Commenters were concerned that this would result in rote or mechanical price challenges that may be unnecessary, while not covering price challenges that may be appropriate based on facts and circumstances not readily susceptible to being distilled into criteria specified in advance.

100

Commenters stated that the circumstances under which a fund might initiate a price challenge are not always objective or based on set criteria given the myriad of different, and often fluid, data sources and inputs that could lead to challenges.

101

See

Proposing Release,

supra

footnote 2, at text following n.63 (stating that price challenges are typically initiated when pricing information from a pricing service differs materially from the board's or adviser's view of the fair value of an investment).

100

See e.g.,

ICI Comment Letter; JPMAM Comment Letter; John Hancock Comment Letter; Dechert Comment Letter; SIFMA AMG Comment Letter; TRP Comment Letter; Guggenheim Comment Letter; Comment Letter of Jon Hunt and Joseph T. Grause, Trustee and Lead Non-Interested Trustee, Advisors' Inner Circle Funds Trusts (July 23, 2020) (“Advisor's Inner Circle Trustees Comment Letter”); Murphy Comment Letter.

101

See e.g.,

Capital Group Comment Letter; John Hancock Comment Letter.

After considering comments, we agree that there can be a range of circumstances under which a price challenge may be warranted, some of which cannot be distilled into specific criteria in advance.

102

For example, such an approach may lead the valuation designee to challenge pricing information that is reasonable given market conditions, solely because such pricing information meets the pre-established criteria. We believe, however, that appropriate oversight of pricing services includes a rigorous analysis of the pricing information provided by pricing services and any price challenges, where appropriate. Therefore, we are amending this requirement to require that funds establish a process for initiating price challenges, instead of pre-established criteria.

103

Such a process generally should outline the circumstances under which a price challenge should be initiated.

104

102

See e.g.,

ICI Comment Letter; Guggenheim Comment Letter; TRP Comment Letter.

103

See e.g.

SIFMA AMG Comment Letter.

104

If the board designates a valuation designee to perform fair value determinations, the process for initiating price challenges established by the valuation designee is required to be subject to appropriate board oversight under rule 2a-5.

See infra

text accompanying footnotes 214-218 (noting that a valuation designee may have an incentive to value fund assets improperly in order to increase fees and that, therefore, as part of the board's oversight responsibilities, the board should seek to identify such potential conflicts of interest, monitor such conflicts, and take reasonable steps to manage such conflicts).

Several commenters urged the Commission to provide additional guidance concerning who would qualify as a pricing service under the final rule.

105

Two commenters stated that the term “pricing service” as used in the Proposing Release is not entirely consistent with the definition in the Public Company Accounting Oversight Board (PCAOB) standards for auditing fair value measurements.

106

We are not adopting a specific list of criteria for who may qualify as a pricing service because we believe that it may become outdated over time and that the scope of the term “pricing service” is generally understood by boards and valuation designees. However, as we stated in the Proposing Release, we refer to pricing services as 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.

107

We believe that the types of entities that would be pricing services under the final rule would include pricing services as defined in the PCAOB standards.

108

105

See e.g.,

Comment Letter of Refinitiv Evaluated Pricing Service (July 21, 2020) (“Refinitiv Comment Letter”); Comment Letter of ICE Data Pricing & Reference Data, LLC (July 21, 2020) (“ICE Data Comment Letter”); Capital Group Comment Letter; AIMA Comment Letter; Comment Letter of KPMG (July 20, 2020) (“KPMG Comment Letter”); Comment Letter of Duffs and Phelps (July 21, 2020) (“Duff & Phelps Comment Letter”); Comment Letter of the American Society of Appraisers (July 21, 2020) (“ASA Comment Letter”).

106

See

KPMG Comment Letter;

see also

Duff & Phelps Comment Letter.

107

See

Proposing Release,

supra

footnote 2, at text accompanying n.60.

108

See

PCAOB AS 2501.

Some commenters suggested we also include a specific requirement for a fund's board or adviser, as applicable, to periodically review the selection of pricing services and to evaluate other pricing services.

109

Two commenters, in contrast, stated that such a requirement would be unnecessary because the compliance rule already requires periodic reviews of service providers, including fund pricing services.

110

We believe that a specific requirement to review the selection of pricing services is unnecessary in light of the reporting requirements of rule 2a-5, discussed

below.

111

We think that the board or the valuation designee should, as part of their annual review of the adequacy and effectiveness of the fair value process, consider the adequacy and effectiveness of the pricing services used given the important role that information provided by pricing services can play in the fair value process.

109

See

Council of Institutional Investors Comment Letter; VRC Comment Letter; IHS Markit Comment Letter.

110

ICE Data Comment Letter;

see also

Refinitiv Comment Letter; Murphy Comment Letter. We disagree with these commenters.

See

Compliance Rules Adopting Release,

supra

footnote 82, at n.28 (stating that the term “service provider” as used in the Compliance Rules Adopting Release does not include pricing services).

111

See infra

section II.B.2.

In addition, several commenters stated that the oversight of pricing services requirements under rule 2a-5 may not be consistent with previous guidance regarding the use of pricing services in the 2014 Money Market Fund Release, particularly regarding the role of the board of directors.

112

Some of these commenters urged us to rescind that guidance and holistically address oversight of pricing services in this Adopting Release.

113

112

See

MFDF Comment Letter; Fidelity Trustees Comment Letter; Comment Letter of Independent Directors Council (July 16, 2020) (“IDC Comment Letter”); NYC Bar Comment Letter; ABA Comment Letter; American Funds Trustees Comment Letter.

113

ABA Comment Letter; IDC Comment Letter; Fidelity Trustees Comment Letter.

See also

Advisor's Inner Circle Trustees Comment Letter (stating its belief that the list of factors set out in the Proposing Release exceeds what is reasonably necessary to oversee pricing services, and offering, as an example, that review of a pricing service's valuation methods or techniques, inputs and assumptions is inconsistent with the role of an overseer of pricing services). The specific factors with which the commenter had concerns were also included in the guidance in the 2014 Money Market Fund Release. We disagree with the commenter because we believe that a review of a pricing service's valuation methods or techniques, inputs, and assumptions is a necessary factor of effective oversight by the valuation designee or the board, as applicable.

We believe that the requirements of the final rule and the guidance provided in this section effectively address the concerns with oversight of pricing services discussed as part of the fair value guidance in the 2014 Money Market Fund Release. We state below our views on how oversight and selection of pricing services may be effectively conducted, which is largely consistent with our previous guidance from the 2014 Money Market Fund Release guidance but reflects the process established in rule 2a-5 allowing the board to designate the valuation designee to perform fair value determinations.

114

The guidance below also includes certain additional factors that were included in the Proposing Release.

115

Our views stated below supersede the guidance the Commission expressed in the 2014 Money Market Fund Release regarding the use of pricing services, and so we are rescinding that guidance.

116

114

See

Proposing Release,

supra

footnote 2, at text following n.154 (requesting comment on whether the Commission should rescind any other valuation guidance in light of the proposal).

115

See

Proposing Release,

supra

footnote 2, at text accompanying nn.62-63.

116

This rescission is limited to section III.D.2.b of the 2014 Money Market Fund Release entitled “Use of Pricing Services.” The guidance in that release on the use of amortized cost valuation remains valid.

See also supra

footnotes 64-67 and accompanying text (discussing the rescission of certain guidance we provided in the 2014 Money Market Fund Release regarding thinly traded securities).

We believe that under the final rule, before deciding to use a pricing service, the fund's board or valuation designee, as applicable, 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

117

used by the pricing service for different classes of holdings, and how they are affected (if at all) as market conditions change;

118

(iii) the quality of the pricing information provided by the service and the extent to which the service determines its pricing information as close as possible to the time as of which the fund calculates its net asset value;

119

(iv) the pricing service's process for considering price challenges, including how the pricing service incorporates information received from price challenges into its pricing information; (v) the pricing service's actual and potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts;

120

and (vi) the testing processes used by the pricing service.

121

In addition, the fund's board or valuation designee, as applicable, should generally consider the appropriateness of using pricing information provided by a pricing service in determining the fair values of the fund's investments where, for example, the fund's board or valuation designee, as applicable, does not have a good faith basis for believing that the pricing service's pricing methodologies produce prices that reflect fair value.

122

117

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 valuation designee or its affiliates.

See

Proposing Release,

supra

footnote 2, at n.62.

See also

Stradley Comment Letter and Advisor's Inner Circle Trustees Comment Letter (noting that the proposed policies and procedures required under rule 2a-5 were duplicative and would be unnecessarily burdensome to boards).

Rule 38a-1 requires a fund's board, including a majority of its independent directors, to approve the fund's policies and procedures, and those of each 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.

126

We agree that, after our adoption of rules 2a-5 and 31a-4, the compliance rule by its terms will require the adoption and implementation of written policies and procedures reasonably designed to prevent violations of the requirements of rules 2a-5 and 31a-4 (“fair value policies and procedures”).

127

Accordingly, final rule 2a-5 does not include a separate policies and procedures requirement.

126

17 CFR 270.38a-1(a)(2).

See also

Compliance Rules Adopting Release,

supra

footnote 82.

127

See, e.g.,

Seward & Kissel Comment Letter; ABA Comment Letter; Fidelity Comment Letter; Advisor's Inner Circle Trustees Comment Letter; NYC Bar Comment Letter.

See

Compliance Rules Adopting Release,

supra

footnote 82, at nn.39-47.

While the adopting release for the compliance rule included a discussion

of certain policies and procedures for determination of fair value that a fund should adopt, this discussion occurred prior to our adoption of rule 2a-5.

128

Rule 2a-5 creates a new framework for fair value determinations. As we stated in the Proposing Release, the requirements of rule 2a-5 and guidance in this release will supersede the Compliance Rules Adopting Release's discussion of policies and procedures for the pricing of portfolio securities and fund shares.

129

Accordingly, to comply with the compliance rule, each fund must adopt and implement fair value policies and procedures that are reasonably designed to prevent violations of new rules 2a-5 and 31a-4's requirements. Because rules 2a-5 and 31a-4 are new rules under the Act with new fair value determination requirements, and given the intrinsic relationship of the rules to the board's own statutory functions relating to valuation, the fair value policies and procedures must be approved by the board pursuant to rule 38a-1 and may not be considered material amendments to existing fair value policies and procedures.

130

128

See

Compliance Rules Adopting Release,

supra

footnote 82, at nn.39-47.

129

See

Proposing Release,

supra

footnote 2 at n.69.

130

Additionally, as discussed below, rule 2a-5 continues to contain certain board reporting requirements specifically tailored to the requirements of the final rule. While the compliance rule separately requires the fund's chief compliance officer (“CCO”) to provide an annual report to the fund's board that addresses the operation of these policies and procedures, including any material changes to these policies and procedures, rule 2a-5's reporting requirements address a different set of concerns.

See

rule 38a-1(a)(4)(iii)(A).

See also

Compliance Rules Adopting Release,

supra

footnote 82.

Where the board determines the fair value of investments, the fund will adopt and implement the fair value policies and procedures under the compliance rule.

131

Similarly, where the board designates the adviser as valuation designee to perform fair value determinations under rule 2a-5(b), as discussed in section II.B, the adviser will adopt and implement the fair value policies and procedures under the compliance rule. As with a fund adopting fair value policies and procedures, the adviser's fair value policies and procedures must be approved by the board pursuant to rule 38a-1 and may not be considered material amendments to existing fair value policies and procedures. This approach clarifies, as some commenters requested, that the board can fulfill its responsibilities under the compliance rule if the adviser adopts fair value policies and procedures without the need for the fund to adopt duplicative policies separately.

132

Additionally, we believe that this approach helps to ensure that fair value policies and procedures include an appropriate amount of detail, while preserving a certain level of flexibility for the board or adviser, as applicable, to tailor the fair value policies and procedures to the unique facts and circumstances of the fund.

133

131

For an internally-managed fund, the fair value policies and procedures will be adopted by the fund regardless of whether the board determines the fair value of investments itself or designates an officer of the fund to perform fair value determinations.

132

See

Advisor's Inner Circle Trustees Comment Letter (requesting that the Commission clarify that a board can fulfill its responsibilities under rule 38a-1 by approving the adviser's fair value policies as reasonably designed to prevent violation of the Federal securities laws, without the investment company's having to “adopt” its own or the adviser's policies); NYC Bar Comment Letter. Furthermore, as we stated in the Proposing Release, 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 not be affected by the final rule.

133

See, e.g.,

SBIA Comment Letter; University of Miami Comment Letter; MFS Comment Letter; Vanguard Comment Letter; ABA Comment Letter; BlackRock Trustees Comment Letter (arguing that rule 2a-5 should give fund boards flexibility in developing fair value policies and procedures).

But see

IVSC Comment Letter (urging the Commission to consider requiring additional prescriptive elements that should be included in fair value policies and procedures).

B. Performance of Fair Value Determinations

Largely as proposed, under the final 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 final rule, including, among other things, selecting and applying valuation methodologies.

134

A board could also designate the performance of fair value determinations relating to any or all fund investments to a valuation designee, subject to the board's oversight. The final rule will require the valuation designee to make certain reports to the board, specify responsibilities regarding fair value determinations, and reasonably segregate portfolio management from fair value determinations.

135

The trustee or depositor will generally perform the fair value functions in paragraph (a) of the final rule for UITs, which do not have a board or adviser.

136

These provisions are designed to provide boards, valuation designees, and other parties involved with a consistent approach to the allocation of fair value functions that recognizes the important role that valuation designees can play in the fair value process, while also preserving a crucial role for boards to fulfill their obligations under section 2(a)(41) of the Act by meeting the requirements of the final rule.

137

134

In this circumstance, the fund would need to adopt and implement policies and procedures under rule 38a-1 to address valuation issues and keep records consistent with the requirements of the rules.

See

rules 2a-5(b), 31a-4, and 38a-1(a)(1).

135

Rule 2a-5(b).

136

Rule 2a-5(d).

see also

John Hancock Comment Letter (stating that if the administrator is an affiliate of the adviser, the board can exercise oversight through its relationship with the adviser and that staff guidance provides some further protections); Advisor's Inner Circle Trustees Comment Letter (recommending permitting reporting by non-advisers, such as fund administrators and pricing services).

144

See

ICI Comment Letter; Seward & Kissel Comment Letter.

145

See

CFA Institute Comment Letter; Dimensional Comment Letter.

But see

ICE Data Comment Letter (recommending that pricing services not be permitted to be assigned).

146

See

CFA Institute Comment Letter.

But see

ICE Data Comment Letter (recommending that accounting firms not be permitted to be assigned).

147

See

Murphy Comment Letter; VRC Comment Letter; Advisor's Inner Circle Trustees Comment Letter.

148

See

Sullivan Comment Letter; Deloitte Comment Letter; Seward & Kissel Comment Letter; SBIA Comment Letter; NYC Bar Comment Letter;

see also

Dechert Comment Letter; Franklin Comment Letter (recommending permitting officers generally).

These commenters suggested that an expanded list of permissible entities would more accurately reflect current organizational structures and practices, would make it easier for smaller funds to comply with rule 2a-5, and would facilitate boards that would prefer non-advisers that may have fewer conflicts of interest.

149

Some commenters believed it was unnecessary for the party performing fair value determinations to be a fiduciary of the fund.

150

In contrast, others suggested that a fiduciary relationship is important.

151

149

See

ICI Comment Letter; IDC Comment Letter; Russell Comment Letter; Seward & Kissel Comment Letter (stating that advisers could raise their fees in response to the proposed rule, resulting in higher costs for funds if they can only assign to advisers).

150

See

Seward & Kissel Comment Letter; Russell Comment Letter;

see also

Harvest Comment Letter (stating that fiduciary duties or registration status should not matter and that the board should only assign to third parties based upon experience, expertise, accuracy, and documentation and be fully vetted).

151

See generally

IHS Market Comment Letter (recommending that we agree that pricing services are acting as fiduciaries when involved in the valuation process). We did not propose to require pricing services to act as fiduciaries as part of this rulemaking, and do not believe that it is appropriate to make such a mandate as part of this adoption.

We generally decline to expand permissible designees beyond the adviser in the final rule because we believe that it is critical for the entity actually performing the fair value determinations to owe a fiduciary duty to the fund and be subject to direct board oversight whenever possible.

152

While these other parties may not have the same conflicts as an adviser, they also generally have other conflicts that could influence their fair value determinations. For example, pricing services may have an interest in maintaining continuing business relationships with the adviser or fund, which could present conflicts

153

and in such cases, unlike advisers,

154

their performance of fair value determinations may not be subject to the same fiduciary obligations owed to the fund.

155

We believe that having fiduciary obligations to the fund will help ensure that the party performing fair value determinations acts in the fund's best interest and, as appropriate, eliminates, mitigates, or discloses conflicts.

156

Further, we believe that it is important for the valuation designee to have a direct relationship with the fund's board and have comprehensive and direct knowledge of the fund.

157

This is true of the fund's adviser, whose advisory contract is subject to substantive board oversight pursuant to the Act,

158

or, in the case of internally-managed funds, officers of the fund. To the extent that other parties provide services that are essential for fair value determinations, the board or valuation designee can seek their assistance as discussed below.

152

See, e.g.,

Proposing Release,

supra

footnote 2, at 106.

153

See also supra

section II.A.4 (discussing these conflicts).

154

See infra

footnote 219 and accompanying text.

155

See also

SBIA Comment Letter (arguing that officers of internally managed funds should be permitted to perform fair value determinations because officers of such funds generally have fiduciary and similar duties to the fund and its equity holders).

161

Rule 2a-5(e)(4). Because these officers are “valuation designees” under the final rule, they will be required to perform all the functions rule 2a-5 will require of valuation designees, including the mandatory board reporting.

In the Proposing Release, we stated that the proposed rule would permit boards to assign either to the fund's primary adviser or one or more sub-advisers.

162

While some commenters generally supported the flexibility this interpretation would afford,

163

others opposed or had concerns about it, arguing that sub-advisers do not currently perform this task and permitting them to do so could significantly increase costs.

164

Some did not object to the flexibility but stated that having sub-advisers involved in valuation was inconsistent with some current practices, with some questioning if this would be an appropriate role for a sub-adviser.

165

A number of commenters raised concerns about how permitting assignment to

sub-advisers would work in practice, for example, how to resolve conflicting fair value determinations,

166

and requested that we provide guidance on how to reconcile in such circumstances.

167

162

Proposing Release,

supra

footnote 2, at 33-34.

163

See, e.g.,

TRP Comment Letter; IAA Comment Letter; CFA Institute Comment Letter; Vanguard Comment Letter.

164

See

MFS Comment Letter; Seward & Kissel Comment Letter.

165

See

Capital Group Comment Letter; IAA Comment Letter; SIFMA AMG Comment Letter;

see also

TRP Comment Letter (noting it could increase costs to assign to a sub-adviser).

166

See

Seward & Kissel Comment Letter; SIFMA AMG Comment Letter.

167

See

Capital Group Comment Letter; CFA Institute Comment Letter; MFS Comment Letter; IAA Comment Letter;

see also

SIFMA AMG Comment Letter.

The final rule will not permit boards to designate the performance of fair value determinations to fund sub-advisers.

168

However, consistent with the guidance below, boards or their valuation designee can seek the assistance of sub-advisers as they see appropriate. We proposed allowing designation to sub-advisers as a method to provide additional flexibility to boards. After considering the increased complexity identified by commenters that this flexibility may create, and commenters' assertions that sub-advisers typically do not currently serve in this role,

169

we have determined that any benefits provided by this additional flexibility would not be justified by the additional challenges it may create. We also are concerned that allowing designation to sub-advisers may create complicated reconciliation and oversight issues for boards, advisers, and sub-advisers. However, we welcome engagement with respect to the role of sub-advisers in the fair value determination process.

168

Rule 2a-5(e)(4) (defining “valuation designee” as, among other things, an adviser other than a sub-adviser).

169

See

MFS Comment Letter; Seward & Kissel Comment Letter.

The proposed rule would have permitted only the UIT's trustees to perform fair value determinations.

170

Commenters stated that the final rule should permit the parties specified as evaluators in the UIT's trust indenture or similar document, including the depositor and other entities, to perform fair value determinations under rule 2a-5. These commenters argued that these evaluators are the entities with relevant expertise in valuation matters and this change would make rule 2a-5 more consistent with current practice.

171

Others asked that we not apply the final rule's requirements to existing UITs given their trust indentures are currently drafted to permit entities other than trustees to value the UITs' investments.

172

One commenter stated that the cost to implement the proposed rule could be significant for UITs due to the change in practice.

173

170

Proposed rule 2a-5(d).

171

See

ICI Comment Letter; Comment Letter of Chapman and Cutler LLP (July 20, 2020) (“Chapman Comment Letter”); Comment Letter of Advisers Asset Management, Inc. (July 20, 2020) (“AAM Comment Letter”); Comment Letter of First Trust Portfolios L.P. (July 21, 2020) (“First Trust Comment Letter”); Comment Letter of Hennion & Walsh, Inc. (July 20, 2020) (“Hennion & Walsh Comment Letter”); Invesco Comment Letter; Comment Letter of the Bank of New York Mellon (July 20, 2020) (“BNY Mellon Comment Letter”);

see also

Seward & Kissel Comment Letter (suggesting permitting UIT trustees to assign to any assignee).

172

See

Chapman Comment Letter; AAM Comment Letter; First Trust Comment Letter.

173

See

BNY Mellon Comment Letter. Some commenters also asked that we clarify that the oversight elements of paragraph (b) do not apply to UITs.

See

Chapman Comment Letter; AAM Comment Letter; First Trust Comment Letter; Hennion & Walsh Comment Letter; BNY Mellon Comment Letter. Because paragraph (b) only applies when a board designates the performance of fair value determinations to a valuation designee, which a UIT will not have, we agree that it is inapplicable to UITs.

In other contexts under the Investment Company Act, the Commission has provided for a UIT's depositor to conduct activities that the board of directors would otherwise conduct, given that a UIT has neither a board of directors nor an adviser.

174

UIT depositors are subject to liability under section 36(a) of the Act for breach of fiduciary duty.

175

We agree, in light of these comments, that UITs should not be limited to trustees to perform their fair value determinations. As we understand that the trustee traditionally has not performed fair value determinations, and we have recognized in the past that depositors generally serve the most equivalent function to an adviser for UITs,

176

the final rule will permit either the fund's depositor or trustee to perform the fair value determinations required under rule 2a-5.

177

To the extent that the assistance of other parties (such as evaluators) is necessary, trustees or depositors can seek that assistance consistent with the guidance below regarding obtaining the assistance of others.

174

See, e.g.,

17 CFR 270.17j-1(c)(1)(iii) (“rule 17j-1”) and 38a-1(b).

175

See

section 36 of the Act;

see also

Memorandum on the Regulation of Unit Investment Trusts from the Division of Investment Management to the Securities and Exchange Commission, Fed. Sec. L. Rep. (CCH) 84,328 (Sep. 22, 1988).

176

See, e.g.,

items 25 through 31 of Form N-8B-2 (requiring information regarding depositors that is similar to that required of an adviser to a management company in item 10 of Form N-1A).

177

Rule 2a-5(d).

In recognition of commenters' statements that there would be significant costs for pre-existing UITs to change who engages in the fair value determination as they might need to amend their trust indenture (and potentially obtain a unit holder vote approving the change) we are grandfathering existing UITs under limited circumstances. Thus, the final rule will now require trustees or depositors to perform fair value determinations if the UIT's date of initial deposit (which would include a rollover) of portfolio securities occurred after the effective date of rule 2a-5. If the initial deposit of securities into the UIT took place

prior

to the effective date of the final rule, to the extent that an entity other than the UIT's trustee or depositor has been designated in the trust indenture to perform fair value determinations, that previously designated entity may perform such fair value determinations pursuant to paragraph (a) of the final rule.

178

We believe that this approach should be acceptable, even though the party making fair value determinations under this provision may not be subject to the same fiduciary duties, as this outcome reflects a balancing of the costs and risks, informed by the unmanaged and fixed nature of these UITs, and because of the limited nature of this relief.

179

Further, we believe that the number of these funds that will be able to utilize an entity other than a depositor or trustee will be small and decrease over time.

180

We are also concerned that it would be unlikely that pre-existing UITs could comply with the final rule absent this provision given the statutory requirement that UITs be organized under a trust indenture, contract of custodianship or agency, or similar instrument (the terms of which, in these limited cases, provide for an evaluator other than the trustee or depositor). Further, we believe that this approach should address commenter concerns about disrupting existing UIT fair value determination designees and the associated potential costly changes which could affect investors if the costs are passed on to them.

178

To be clear, this exception from the requirement to utilize a depositor or trustee for fair value determinations will not continue to be available when a pre-existing UIT is rolled over to a new UIT after the termination date of the pre-existing UIT. In such a case, when the rollover occurs, the new UIT will be required to designate either the depositor or trustee to perform fair value determinations consistent with the final rule. In addition, if a pre-existing UIT has a trustee or depositor already designated to perform the fair value determination, then that entity would be the entity responsible for performing the fair value determination requirements under the final rule.

179

See generally

Fund of Funds Arrangements, Investment Company Release No. 34045 (Oct. 17, 2020) [85 FR 73924 (Nov. 19, 2020)] (“FOF Adopting Release”) at 92.

180

We believe that the universe of UITs relying on this exception will be small.

See infra

footnote 550 and accompanying text. Further, as we have noted previously, many existing UITs have a limited term, sometimes of approximately 12 to 18 months. FOF Adopting Release,

supra

footnote 179, at n.332 and accompanying text.

As proposed, the final rule defines “board” both as the full board or a designated committee thereof composed of a majority of directors who are not interested persons of the fund.

181

We received limited comments on this aspect of the proposal. One commenter, however, suggested that the fund should be required to develop policies and procedures for when the whole board, rather than a committee, would be required to be involved.

182

Conversely, another stated that because state law permits fund boards to empower specific committees to act on behalf of the entire board, rule 2a-5 was sufficient as proposed.

183

We believe that no such changes are necessary to this provision because it is important that boards be able to utilize specialized committees, particularly on matters as detailed and important as valuation. Should a fund choose to develop policies and procedures regarding when a matter is more appropriate for the full board, it can do so, but it will not be required under the final rule.

181

Rule 2a-5(e)(3).

182

See

IVSC Comment Letter.

183

See

Murphy Comment Letter.

One commenter wanted clarification that the fund's adviser could perform fair value determinations on the board's behalf regardless of whether it is acting pursuant to an advisory contract, administrative contract, or similar agreement.

184

Another asked that we clarify when a pricing service that is a Commission-registered adviser would be considered an “investment adviser” for purposes of the final rule.

185

The final rule, consistent with the proposal, provides that where the valuation designee is an adviser, it must be an “adviser of the fund.” This would not include other service providers, whether or not they are registered as advisers, or acting under a contract with the fund, unless they are actually serving as the adviser of the fund as defined under the Investment Company Act because they may not have a comprehensive and direct knowledge of the fund, a direct relationship with the board, or the same fiduciary duties to the fund in other cases.

186

As discussed above, it also would not include a sub-adviser to the fund.

184

See

John Hancock Comment Letter.

185

See

ICE Data Comment Letter.

186

See

section 2(a)(20) (defining investment adviser of an investment company).

See also supra

footnotes 152-156 and accompanying text (explaining why we are generally not permitting parties other than the adviser to be valuation designees under the final rule).

Guidance on Obtaining the Assistance of Others

Some commenters also asked that we clarify that the adviser or the fund board could engage third parties to assist with certain functions of the fair value determination process, such as performing back-testing, fund accounting, or shareholder reporting, other than making the actual determinations themselves.

187

Others urged us to state that advisers assigned to perform fair value determinations under the proposed rule could, in turn, assign their responsibilities to other third parties.

188

187

See

Sullivan Comment Letter; Fidelity Comment Letter; NYC Bar Comment Letter (asserting fund boards must be able to rely upon fund auditors and counsel); Dechert Comment Letter.

188

See

Russell Comment Letter.

We believe that whether the board or the valuation designee makes fair value determinations under the final rule, it may of course obtain assistance from others in fulfilling its duties. It may, for example, seek assistance from pricing services, fund administrators, sub-advisers, accountants, or counsel.

189

That assistance can take different forms, and may include services such as performing back-testing as specified by the valuation designee and performing calculations required by the valuation method selected by the board or valuation designee. The board or the valuation designee, using this assistance, must of course also perform its responsibilities under the Act, the final rule, and other applicable rules under the Act. However, in seeking the assistance of others, the entity or officer designated to perform the fair value determination remains responsible for that determination and may not designate or assign that responsibility to the third party for the same reasons we are not permitting the board to designate performance of this task to a party other than the valuation designee.

190

189

For example, some commenters suggested that the administrator may be better positioned to perform the fair value determinations under rule 2a-5 than an adviser.

See

Sullivan Comment Letter. For the reasons discussed above, we determined generally to limit the valuation designee to the fund's adviser.

See supra

footnotes 152-158 and accompanying text.

190

See supra

footnotes 152-158 and accompanying text.

1. Board Oversight

The final rule, consistent with the proposal, specifically requires a board to oversee the valuation designee if the board has designated the performance of fair value determinations to the valuation designee.

191

In the proposal, we provided guidance on our expectations related to this board oversight.

192

A number of commenters supported this guidance,

193

with one commenter stating that the discussion properly reflects the general roles of boards and advisers under both current practices of properly functioning boards as well as Federal and state law.

194

However, other commenters questioned parts of the guidance or asked that we provide further guidance on certain issues.

191

Rule 2a-5(b).

192

Proposing Release,

supra

footnote 2, at nn.84-94 and accompanying text.

193

See

Council of Institutional Investors Comment Letter; Fidelity Comment Letter; VRC Comment Letter; Invesco Comment Letter; CFA Institute Comment Letter; Comment Letter of Better Markets (July 21, 2020) (“Better Markets Comment Letter”);

see also

IDC Comment Letter (agreeing with the lack of specificity of “oversight” in the proposed rule). One of these commenters recommended that we require that boards have the requisite experience, knowledge, and sufficient lack of conflicts to fulfill their obligations. Better Markets Comment Letter. Another suggested that directors be required to have “valuation literacy.” CFA Institute Comment Letter. The commenter did not clarify what is meant by “valuation literacy” and we do not believe that an affirmative requirement is necessary. However, the board's statutory obligation for determining fair value in good faith, as well its oversight obligation with respect to any valuation designee under new rule 2a-5, generally warrants consideration of the appropriateness of director qualifications, such as with respect to accounting and valuation matters, when funds and boards are identifying potential board candidates. The Commission understands that board members are often selected to provide a variety of specialized knowledge and experience, including in accounting and valuation.

194

See

Fidelity Comment Letter;

see also

ICI Comment Letter (stating that the proposal correctly distinguished oversight from design and administration).

Some of these commenters argued that board oversight of the valuation process should be the same as the oversight of other functions, such as liquidity risk.

195

While we agree that boards should provide oversight in those contexts as well, we believe that we should provide specific guidance with respect to board oversight in the context of making fair value determinations. We believe that specific guidance is appropriate because section 2(a)(41) is one of the few provisions of the Act that specifically imposes a requirement on fund boards, requiring boards to determine fair value in good faith. Therefore, this guidance supports our view that a board may still satisfy its statutory obligation to determine fair

value even though it has designated another entity to perform the fair value determinations under the final rule, subject to appropriate oversight.

196

195

See

MFDF Comment Letter; ABA Comment Letter (requesting the Commission to reiterate, as it had in the adopting release for 17 CFR 270.22e-4 (“rule 22e-4”), that the board role under this rule is substantially similar to its roles and responsibilities in other contexts under the Act and that providing a different standard of care for board action would not be appropriate); Advisor's Inner Circle Trustees Comment Letter;

see also

NYC Bar Comment Letter.

196

See

section 1(b) of the Act (“it is hereby declared that the national public interest and the interest of investors are adversely affected . . . when investment companies, in computing their earnings and the asset value of their outstanding securities . . . are not subjected to adequate independent scrutiny”).

A number of commenters questioned the guidance stating that boards must be active in their oversight role by probing reports written by advisers and being inquisitive,

197

but other commenters agreed that board oversight cannot be a passive activity.

198

We believe that boards are not providing appropriate oversight if they simply rely on information presented to them without actively probing it, asking questions, and seeking relevant information, particularly when there are red flags or other indications of problems. Some commenters asked us to state that the board does not have an independent duty to seek to discover conflicts of interest but can reasonably rely upon the adviser's identification of these conflicts,

199

but one stated we should clarify that the board has an affirmative duty to do so.

200

Another stated that the board should be able to rely upon the adviser much the same way that it can reasonably rely upon others, such as fund CCOs, administrators, and counsel.

201

As discussed below in the guidance on board oversight, we are reiterating our belief, stated in the Proposing Release, that boards should seek to identify potential conflicts of interest as part of their oversight duties under the final rule. Boards must work with valuation designees, which also have a duty to disclose their conflicts,

202

to address or manage these conflicts to the board's satisfaction.

197

See

IDC Comment Letter; ABA Comment Letter; Stradley Comment Letter; Capital Group Comment Letter; Advisor's Inner Circle Trustees Comment Letter;

see also

NYC Bar Comment Letter (stating that oversight should consist of reviewing reports and determining corrective action); Dechert Comment Letter; American Funds Trustees Comment Letter.

Cf.

Proposing Release,

supra

footnote 2, at nn.89-94 and accompanying text.

198

See

Fidelity Comment Letter; Invesco Comment Letter; CFA Institute Comment Letter; Better Markets Comment Letter.

199

See

Sullivan Comment Letter; ABA Comment Letter.

200

See

CFA Institute Comment Letter.

201

See

IDC Comment Letter; Stradley Comment Letter.

202

See, e.g.,

Commission Fiduciary Interpretation,

supra

footnote 156, at n.24.

Although several commenters asked us to confirm that boards may provide oversight of the performance of fair value determinations consistent solely with the business judgment rule under state law, we decline to do so.

203

Instead, we are providing guidance that we believe should be more useful to directors than the more generalized principles of the business judgment rule, as this new guidance specifically relates to directors' oversight responsibilities under section 2(a)(41) of the Act and the final rule.

203

See

ABA Comment Letter; Stradley Comment Letter.

Finally, several commenters recommended that we adopt additional oversight requirements, such as third-party reviews, attestations, or certifications by the adviser,

204

or that we require the board to make specific findings.

205

Others argued that additional requirements were unnecessary due to state law duties applicable to boards or because the expense was not justified by the regulatory benefits.

206

Several commenters also asked that we clarify whether directors are expected to ratify fair value determinations made by the adviser under rule 2a-5.

207

We are not adding specific oversight requirements in the final rule beyond those that were proposed. We believe that the oversight requirements of boards under the final rule, discussed below, taken together with the directors' fiduciary duties, are reasonably designed to establish a minimum set of requirements for addressing the conflict of interest and other concerns associated with permitting a valuation designee to make fair value determinations. As such, we believe that additional requirements like those suggested by these commenters may be duplicative or involve burdens that are not justified by their potential benefits. The final rule does not require boards to ratify fair value determinations made by the valuation designee, as we believe it is not a necessary component of active oversight.

204

See

IVSC Comment Letter; CFA Institute Comment Letter;

see also

ABA Comment Letter (recommending a certification by the adviser similar to that required in rule 17j-1); Council of Institutional Investors Comment Letter (supporting an attestation requirement).

205

See

ICE Data Comment Letter; Murphy Comment Letter.

206

See

Murphy Comment Letter; Comment Letter of Timothy Keehan, Vice President & Senior Counsel, American Bankers Association (“American Bankers Association Comment Letter”).

207

See

ABA Comment Letter.

Guidance on Board Oversight

We reiterate the guidance on board oversight of the fair value determination process from the Proposing Release.

208

When the board designates the performance of fair value determinations to the valuation designee, the final rule will require the board to satisfy its statutory obligation with respect to these determinations through the framework of rule 2a-5, including overseeing the valuation designee. Boards should approach their oversight of the performance of fair value determinations by the valuation designee 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.

209

Further, in our view appropriate oversight cannot be a passive activity. Directors should ask questions and seek relevant information.

208

Proposing Release,

supra

footnote 2, at nn.84-94 and accompanying text.

209

See generally

Investment Company Governance, Investment Company Act Release No. 26520 (July 27, 2004) [69 FR 46378 (Aug. 2, 2004)] (“Governance Release”).

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.

210

The final rule will require the valuation designee to report to the board with respect to matters related to the valuation designee's fair value process, in part to ensure that the board has sufficient information to conduct this oversight.

211

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

212

210

Cf.

Derivatives Adopting Release,

supra

footnote 6 (noting that “the use of the word `iterative' is not intended to imply that the board is responsible for the day-to-day management of the fund's derivatives risk, but is instead intended to clarify that the board's oversight role requires regular engagement with the derivatives risk management program rather than a one-time assessment”).

211

Rule 2a-5(b)(1).

212

See also

Governance Release,

supra

footnote 209 (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”).

We 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.

213

For a discussion of valuation 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.

214

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

215

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

216

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 valuation designee)

217

or may otherwise be subject to pressures to provide pricing estimates that are favorable to the valuation designee.

218

In overseeing the valuation designee'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 valuation designee as part of the process, and satisfy itself that any conflicts are being appropriately managed.

214

See, e.g.,

Governance Release,

supra

footnote 209 (“. . . 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.”).

215

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”).

216

See, e.g.,

In re Piper Capital Management, et al., Investment Company Act Release No. 26167 (Aug. 26, 2003) (Commission opinion). For discussion of the conflicts of the fund's portfolio manager, see

infra

section II.B.3. Further, officers of internally managed funds may have other conflicts that boards should consider.

See supra

footnote 159.

217

See supra

footnote 97 and accompanying text.

218

Cf.

In re Morgan Asset Management, Investment Company Act Release No. 29704 (June 22, 2011) (settlement) (“In re Morgan Asset Management”) 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”).

See also supra

footnote 154 and accompanying text.

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

219

In addition, boards should consider the valuation designee's compliance capabilities that support the fund's fair value processes, and the oversight and financial resources available for the fair value process.

219

See

In re Morgan Asset Management,

supra

footnote 218 (“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 final rule will require reporting to the board (both periodically and promptly) regarding many aspects of the valuation designee'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 valuation designee and other service providers in conducting appropriate oversight, it is incumbent on the board to request and review such information as may be necessary to be informed of the valuation designee's process for determining the fair value of fund investments.

220

Further, if the board becomes aware of material matters (whether the board identifies the matter itself or the fund's CCO, valuation designee, 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.

220

In the Proposing Release, we had characterized the board's role as requiring that it be “fully informed” of the adviser's process. Two commenters questioned what that means in this context.

See

Deloitte Comment Letter and ABA Comment Letter. Our intent was to make sure that the board was not solely relying upon the information provided to it by the valuation designee, but was thoughtful and sought additional information when needed. However, we did not intend to imply that the board should be actively managing the process. We have therefore deleted the word “fully” in this release to avoid that implication.

2. Board Reporting

As modified in response to comments received, the final rule will require a valuation designee that the board has designated to perform fair value determinations to report to the board regarding its performance of that responsibility, including certain periodic reports and prompt notification and reporting on matters that materially affect the fair value of investments whose fair value is determined by the valuation designee.

221

These requirements are intended to assist boards in their oversight responsibility under the final rule and to help ensure that boards receive the amount and type of information to oversee the valuation designee appropriately by familiarizing directors with the salient features of, and developments in, the valuation designee's process.

222

These are minimum requirements and boards may find, depending on the facts and circumstances, that additional information is necessary or appropriate in order to discharge their oversight responsibilities appropriately.

221

Rule 2a-5(b)(1).

222

See also

Proposing Release,

supra

footnote 2, at 41-42.

(a) Periodic Reporting

The final rule will require the valuation designee to make both annual and quarterly written reports to the board.

223

Specifically:

223

Rule 2a-5(b)(1)(i).

•

Quarterly Reports.

The valuation designee must provide at least quarterly, in writing, (1) any reports or materials requested by the board related to the fair value of designated investments or the valuation designee's process for fair valuing fund investments and (2) a summary or description of material fair value matters that occurred in the prior quarter. This summary or description must include (1) any material changes in the assessment and management of valuation risks, including any material changes in conflicts of interest of the valuation designee (and any other service provider), (2) any material changes to, or material deviations from, the fair value methodologies,

224

and (3) any material changes to the valuation designee's process for selecting and overseeing pricing services, as well as any material events related to the valuation designee's oversight of pricing services.

225

224

Valuation designees can utilize this report to notify the board of changes to methodologies that are equally or more representative of fair value of the investments.

See supra

section II.A.2.a.

225

Rule 2a-5(b)(1)(i)(A).

•

Annual Reports.

The valuation designee must provide at least annually,

in writing, an assessment of the adequacy and effectiveness of the valuation designee's process for determining the fair value of the designated portfolio of investments. At a minimum, this annual report must include a summary of the results of the testing of fair value methodologies required under the final rule and an assessment of the adequacy of resources allocated to the process for determining the fair value of designated investments, including any material changes to the roles or functions of the persons responsible for determining fair value.

226

Rule 2a-5(b)(1)(i)(B).

After considering comments, we have made certain changes to the proposed periodic reporting requirements designed to enhance flexibility of reporting to better match boards' needs and to minimize the chance that boards receive reporting that is too detailed or repetitive to facilitate appropriate oversight. The proposed rule would have required quarterly reporting on a variety of valuation matters.

227

Commenters raised concerns regarding these proposed reporting requirements. Some stated that, while some reporting is necessary, the proposed reporting requirements were overly prescriptive and would not result in appropriate board oversight in practice.

228

Commenters also generally believed that we should give greater deference to boards to use their business judgment to request the information and the frequency of reports that they see as necessary.

229

Some of these commenters supported a program where the adviser would make quarterly reports on material changes to aspects of, or deviations from, the program, with a broader annual report covering the overall design and implementation of the program.

230

Others recommended that we permit the board to set reporting standards.

231

227

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

228

See, e.g.,

ICI Comment Letter; SSGA Comment Letter; TRP Comment Letter; Guggenheim Comment Letter; Vanguard Comment Letter.

See also

JPMAM Comment Letter.

229

See, e.g.,

Fidelity Trustees Comment Letter; BlackRock Trustees Comment Letter; Murphy Comment Letter; Fidelity Comment Letter (asserting the proposed reporting mechanism would lead to reporting designed to fulfill a regulatory requirement rather than assist with board oversight).

230

See, e.g.,

Sullivan Comment Letter; JPMAM Comment Letter; ICI Comment Letter; IDC Comment Letter; ABA Comment Letter; Murphy Comment Letter.

See also

Federated Hermes Comment Letter; Baillie Gifford Comment Letter (recommending that, to the extent that quarterly reporting is retained, it be permitted to focus on material changes or exceptions and allow summary dashboards).

see also

American Funds Trustees Comment Letter (stating that they rely upon the oversight of the compliance process under rule 38a-1 to perform oversight); SIFMA AMG Comment Letter (urging flexible reporting depending upon the type of inputs).

The proposed rule would have included a number of specific items to be included in the quarterly assessment to boards. Specifically, the proposed rule would have required the quarterly report to include: (1) A summary or description of the assessment and management of material valuation risks (including material conflicts of interest), (2) material changes to, or material deviations from, established fair value methodologies, (3) testing results, (4) adequacy of resources allocated to fair value determinations, (5) material changes to the adviser's process for selecting and overseeing pricing services (including changes in service providers and price overrides), as well as (6) any other materials requested by the board. A number of commenters objected to many of these specific items being reported on a quarterly basis, asserting that the cost to produce them on a quarterly basis would exceed the costs the Commission assumed

232

and the requirements could result in over-reporting to satisfy regulatory obligations or liability concerns rather than to facilitate oversight.

233

Commenters also asserted that many of the reporting items, and particularly valuation risks and adequacy of resources, would not change frequently enough to justify quarterly reporting.

234

Many of these commenters suggested that we instead require advisers to report some or all of these items on an annual basis,

235

or remove some of them altogether, particularly reporting on specific price overrides, to provide more relevant information and to reduce burdens on boards.

236

232

See

Sullivan Comment Letter; TRP Comment Letter; SIFMA AMG Comment Letter; American Trustees Comment Letter.

233

See

TRP Comment Letter; Fidelity Comment Letter; Dechert Comment Letter; SIFMA AMG Comment Letter;

see also

Capital Group Comment Letter.

234

See, e.g.,

Fidelity Trustees Comment Letter; JPMAM Comment Letter; IDC Comment Letter; BlackRock Trustees Comment Letter; Murphy Comment Letter; TRP Comment Letter; Guggenheim Comment Letter; SIFMA AMG Comment Letter; NYSSCPA Comment Letter;

see also

ICI Comment Letter (recommending removing adequacy of resources reporting); Baillie Gifford Comment Letter (recommending removing adequacy of resources reporting).

But see

ABA Comment Letter (recommending that we further require a narrative description of testing results); VRC Comment Letter (suggesting requiring the reporting of specific information on each individual portfolio holding for securities with a higher perceived risk profile).

235

See, e.g.,

Sullivan Comment Letter; JPMAM Comment Letter; ICI Comment Letter; ABA Comment Letter; TRP Comment Letter.

See also

Federated Hermes Comment Letter; Advisor's Inner Circle Trustees Comment Letter; IHS Market Comment Letter (stating that it had observed best practices for reporting on pricing services to be board or committee approval of the provider itself and at least annual review of performance based upon back testing).

236

See, e.g.,

Sullivan Comment Letter; Fidelity Trustees Comment Letter; Murphy Comment Letter; Fidelity Comment Letter;

see also

IAA Comment Letter (stating that significant increases in price challenges or overrides should not be considered a material valuation risk due to their routine nature); American Fund Trustee Comment Letter.

We agree that boards should have latitude to implement a flexible reporting mechanism that is tailored to their fund, recognizes judgment in exercising oversight, and minimizes rote reporting. That said, we believe that appropriate oversight, facilitated by a certain minimum level of reporting, is necessary in order for the designation process to be consistent with the Act.

237

As a result, we are making tailored changes to the proposed periodic reporting regime in the final rule designed to enable boards to receive the information they want and need to conduct appropriate oversight. We believe that the changes we are adopting today will allow reporting to address the specific circumstances of each fund, and reporting should be tailored to address the fund's holdings, valuation methodologies, and inputs, as urged by some commenters.

238

237

See

section 1(b)(5) of the Act and

supra

footnote 196 and accompanying text discussing the need for independent oversight of the valuation process.

238

See, e.g.,

SIFMA AMG Comment Letter.

Specifically, we have made adjustments to the overall proposed periodic reporting requirements. The final rule will require that the valuation designee report its assessment of the adequacy and effectiveness of the valuation designee's process for determining the fair value of designated investments, testing results, and adequacy of allocated resources at least annually rather than quarterly as proposed. In lieu of quarterly assessments of the entire fair value process, the final rule will instead require quarterly reports to address issues about which the board requests information, as well as information about material changes or events that occurred during the period.

239

These

revisions are consistent with the suggestions from commenters noted above that we require annual overall reporting with quarterly updates regarding material changes. We believe that the changes in the final rule establish the necessary minimum reporting needed for appropriate oversight. Further, by expressly recognizing boards' authority to require any additional reports they want on a quarterly basis, the final rule seeks to empower boards to tailor periodic reporting to suit the needs of their fund, as recommended by commenters.

239

Material fair value matters that occurred in the prior quarter related to the items reported on annually, such as significant changes to testing

results or material reductions in the resources provided for the determination process, would, however, still be reported as part of the quarterly material change report.

We have also made adjustments, in response to comments, from the proposal regarding the specific items that will be required to be part of periodic reports. In lieu of a discussion of the assessment and management of material valuation risks as part of the valuation designee's assessment, the final rule will instead require that the quarterly report identify material changes, including the identification of any material changes in the assessment or management of these risks that occurred during the quarter. We agree with commenters that this reporting could become rote if it does not change and have focused it upon material changes as a result.

240

However, boards may wish to consider periodically requesting a report assessing all material valuation risks (not just changes) faced by the fund, so that they remain apprised of the fund's overall valuation risk landscape.

Some commenters suggested that the proposed rule, as worded, would have required the adviser to report every test result, service provider change, or price override to the board, which we did not intend.

241

We agree that these items may have provided a level of detail that may not be necessary. Therefore, we clarified that the annual assessment can contain a summary of testing results and removed a requirement to report service provider changes or price overrides. Lastly, we agree with commenters that the reporting of the summary of testing results and assessment of the adequacy of allocated resources is not needed quarterly because they are unlikely to change on a quarterly basis. Consistent with the overall change to an annual assessment, the final rule will require these results to be reported annually. However, based upon the summaries that they receive, boards can seek more information from the valuation designee if necessary to conduct appropriate oversight.

242

241

See, e.g.,

Sullivan Comment Letter; Fidelity Trustees Comment Letter; Murphy Comment Letter; Fidelity Comment Letter;

see also

242

See supra

section II.B.1.

See also

rule 2a-5(b)(1)(i)(A)(

Some commenters requested more clarification as to what constitutes “material” in the context of the final rule's reporting requirements,

243

suggesting that we create a “material valuation matter” standard that would be reported similar to serious compliance matters under the compliance rule,

244

that we permit the board to define materiality,

245

or use different terminology altogether to avoid confusion with accounting or auditing standards.

246

We believe that material matters in this context would generally be those matters about which the board would reasonably need to know in order to exercise appropriate oversight of the valuation designee's fair value determination process.

247

For example, material matters include significant deficiencies or material weaknesses in internal control over financial reporting related to fair value determinations that have been identified and generally would include those items that “could have materially affected” the fair value of the fund's investments as proposed.

248

We believe that material matters also include other issues, such as a change to a pricing service affiliated with the valuation designee or material changes to or deviations from methodologies, including changes to critical inputs or assumptions.

249

As another example, with regards to material changes to the selection or oversight of pricing services, a pattern of price challenges or overrides over time that raise concerns with the overall valuation process may be material. The valuation designee should identify material issues, and the board should follow-up as necessary for its oversight.

243

See

ABA Comment Letter; MFDF Comment Letter; SIFMA AMG Comment Letter (stating that the industry will likely look to the serious compliance issues standard from rule 38a-1 for guidance); AIMA Comment Letter (with regard to prompt reporting); Deloitte Comment Letter;

see also

University of Miami Comment Letter (suggesting that differences in what constitutes materiality could lead to delays in prompt reporting); MFS Comment Letter (the prompt reporting requirement is unnecessary because of the similarity of materiality in this rule with serious compliance matters under rule 38a-1).

244

See

Stradley Comment Letter; Dechert Comment Letter.

245

See

Vanguard Comment Letter.

246

See

Duff & Phelps Comment Letter.

247

This standard is similar to that of “material compliance matter” found in rule 38a-1.

See

rule 38a-1(e)(2).

248

To align the material matters that would be reported with Commission rules and auditing standards better, we are eliminating the term “could have materially affected” from the final rule and instead are using the term material matter alone. Material matters under the final rule would generally include, for example, material weaknesses and significant deficiencies as defined in 17 CFR 210.1-02(a)(4) that are related to fair value determinations. Some commenters questioned the relevance of financial reporting concepts when reporting regarding fair value determinations.

See

ABA Comment Letter; TRP Comment Letter (regarding prompt, but not periodic, reporting). We believe that these issues can be significant as the lack of sufficient controls over financial reporting could have significant implications in the fund's fair value determinations.

See also

TRP Comment Letter (supporting a system of annual reporting for many items but quarterly reporting for significant deficiencies and material weaknesses in internal controls over financial reporting in lieu of prompt reporting on these items).

249

See

Proposing Release,

supra

footnote 2, at n.104 and accompanying text.

The final rule will require the valuation designee's reports to include such information as may be reasonably necessary for the board to evaluate the matters covered in the reports.

250

Based upon that information, the board can determine whether to ask additional questions or request additional information, as appropriate. For example, if a valuation designee reports that there is a new material conflict of interest, the valuation designee should provide, and the board should seek,

251

additional information as necessary for the board to evaluate the potential impact of the conflict on the adequacy and effectiveness of the valuation designee's determinations of fair value. As another example, where a valuation designee has materially changed a fair value methodology, the report could summarize the relevant market conditions or other circumstances leading to the decision to apply an alternate methodology and the alternate fair value methodology used.

250

Rule 2a-5(b)(1).

251

See supra

section II.B.1 (“Further, in our view effective oversight cannot be a passive activity. Directors should ask questions and seek relevant information.”).

Some commenters were concerned that this requirement will result in advisers providing extraneous or out-of-context information, such as back-testing results, to the board.

252

The specific content of the periodic or prompt reports and supplemental information under the final rule is left to the board and valuation designees. These reports can take the form of narrative summaries, graphical representations, statistical analyses, dashboards, or exceptions-based

reporting, among other methods.

253

Boards should work with valuation designees to determine what information and the format of such information is most useful to the board.

252

See, e.g.,

Capital Group Comment Letter; TRP Comment Letter.

But see

CFA Institute Comment Letter (arguing that the results of testing methods such as calibration/back-testing can assist in identifying issues with methodologies, including poor performance or conflicts of interest).

253

See

ABA Comment Letter (recommending we require the production of narrative summaries of testing results).

In the Proposing Release, we provided a list of specific items that a board could review and consider, if relevant. These included a number of data-driven reporting items like reports regarding portfolio holdings whose price has changed outside of pre-determined ranges over time, reports regarding stale prices, and analyzing trends in the number of the fund's portfolio holdings that received a fair value.

254

See

Proposing Release,

supra

footnote 2, at 46-47.

A number of commenters objected to this list, suggesting that boards and advisers would see these items as mandatory, leading to advisers providing unwanted data to boards in an abundance of caution.

255

The items we identified in the Proposing Release were intended to provide a list of examples of the types of information that a board could request to facilitate data-driven reviews of the fair value process if the board found such information helpful. We continue to believe that boards should request, and valuation designees should provide, such relevant trend dashboards and other analytical tools that the board believes it needs in order to perform appropriate oversight.

256

However, the final rule will not require the production of any particular data or data tool unless the board requests it. We also continue to believe that the types of potential reporting items included in the proposal may be helpful for some boards. They are not mandatory, however. Boards should use their judgment in determining what types of optional reporting they wish to receive beyond the required reporting contained in the final rule.

255

See

Fidelity Trustees Comment Letter; ICI Comment Letter; IDC Comment Letter; ABA Comment Letter (further suggesting that it should be incumbent upon the adviser, similar to the requirements of section 15(c) or 17 CFR 270.12b-1, to provide this type of information, rather than upon the board to request it); MFDF Comment Letter; Fidelity Comment Letter; Vanguard Comment Letter; Capital Group Comment Letter; SIFMA AMG Comment Letter;

see also

Federated Hermes Comment Letter.

256

See, e.g.,

Capital Group Comment Letter (stating that reporting of trends, outliers, and similar analysis of price overrides and challenges would be more helpful for board oversight than requiring all price overrides or challenges to be reported).

(b) Prompt Board Notification and Reporting

With modifications made to address comments received on this aspect of the proposal, the final rule will require the valuation designee to provide a written notification of the occurrence of matters that materially affect the fair value of the designated portfolio of investments (defined as “material matters”) within a time period determined by the board, but in no event later than five business days after the valuation designee becomes aware of the material matter.

257

Material matters in this instance include, as examples, a significant deficiency or material weakness in the design or effectiveness of the valuation designee's fair value determination process or of material errors in the calculation of net asset value.

258

The valuation designee must also provide such timely follow-on reports as the board may reasonably determine are appropriate.

259

This process is designed to ensure that the valuation designee notifies the board of certain issues that may require its immediate attention in a timely manner, but also empower boards to seek the appropriate level of follow-up reporting that they need to exercise appropriate oversight.

257

The proposed rule would have required prompt reporting regarding matters associated with the adviser's process that had this effect. The purpose of this requirement is to inform boards quickly of issues associated with fair value determinations that may require their immediate attention.

See

Proposing Release,

supra

footno

This text is long and has been trimmed here. Open the source document for the complete record.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.