On Monday, the Securities and Exchange Commission (SEC) voted to propose new Rule 2a-5 under the Investment Company Act of 1940 (1940 Act) establishing a framework for funds’ fair value determinations (Proposed Rule). Section 2(a)(41)(B) of the 1940 Act defines “fair value” as valuations “determined in good faith by the board of directors.” The Proposed Rule would expressly permit boards to assign fair value determinations to the fund’s investment adviser, subject to board oversight and certain other conditions. The proposals would apply to open- and closed-end funds and business development companies (BDCs).
Specifically, the Proposed Rule would permit a board to assign the following valuation functions to the fund’s investment adviser, subject to additional oversight requirements: assessing and managing material risks associated with fair value determinations; selecting, applying and testing fair value methodologies; overseeing and evaluating pricing services used, if any; adopting and implementing valuation policies and procedures; and maintaining certain records.
With the delegation to the adviser, the following key guardrails would be required:
As can be seen from the above, although boards would be free from making actual pricing determinations, boards would not be relieved of reviewing significant documentation and overseeing the entire valuation process. In particular, boards will have to review evidence that the adviser satisfies the conditions under which delegation to the adviser is permissible, including that conflicts are handled, risks are evaluated and methodologies resulting in the values determined are sufficiently detailed.
In addition, the proposals would also define “readily available market quotations” in order to align the concept with accounting guidance on fair value for generally accepted accounting principles, particularly ASC Topic 820’s categorization of positions as falling into Level I, II or III accounting buckets. The proposing release identifies Level II and III assets as requiring fair value determination and describes circumstances in which Level I assets’ market quotations are “unreliable” and therefore would require fair value adjustment as well.
The public comment period on the proposals will remain open until July 21, 2020.
The complete SEC release, including the full text of the Proposed Rule, is available on the SEC’s website at: https://www.sec.gov/rules/proposed/2020/ic-33845.pdf.