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SEC Rule 2a-5 Good Faith Determinations of Fair Value

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On December 3, 2020, the Securities and Exchange Commission adopted new rule 17 CFR 270.2a- 5 (“rule 2a-5”) under the Investment Company Act of 1940 that addresses 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. The 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.

The rule codified the common practice of designating the determination of fair value to a fund’s adviser (valuation designee) but requires boards to take specific steps to oversee the designee’s determination of fair value. The rule establishes a framework to help boards consistently oversee this process. The rule, for the first time, defines what the 1940 Act means when it refers to “readily available market quotations.”

Readily Available Market Quotations

As noted in the rule, the board’s role in the valuation of a portfolio holding for purposes of fair value depends on whether or not market quotations are readily available for such a holding. Under section 2(a)(41) of the Investment Company Act, if a market quotation is readily available for a portfolio holding, it must be valued at the market value. Conversely, if market quotations are “not readily available,” the holding’s value must be fair value as determined in good faith by the board. Neither the Investment Company Act nor the rules thereunder currently define “readily available.” However, the SEC understands that industry practice has developed to incorporate many of the concepts of ASC Topic 820 when evaluating whether market quotations are readily available.

Rule 2a-5 provides that a market quotation is readily available for purposes of section 2(a)(41) of the Investment Company Act with respect to a security only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. Fair value, as defined in the Act and further defined in rule 2a-5, therefore must be used in all other circumstances.

The SEC believes that for a fair value methodology to be appropriate under the rule, it must be determined in accordance with U.S. GAAP which requires funds to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. However, under U.S. GAAP there are circumstances where otherwise relevant observable inputs become unreliable. Consistent with this, a quote would be considered unreliable under rule 2a-5(c) in the same circumstances where it would require adjustment under U.S. GAAP or where U.S. GAAP would require consideration of additional inputs in determining the value of the security.

Requirements for Determining Fair Value in Good Faith

The rule provides requirements for determining fair value in good faith by the board of directors and management including:

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

Performance of Fair Value Determinations

The rule permits the fund’s board to designate the fair value determination relating to any or all fund investments to a “valuation designee.” The valuation designee may be the fund’s investment adviser or, if the fund is internally managed, an officer of the fund, which would carry out the functions specified above. The definition of valuation designee expressly excludes a fund’s sub- adviser. In addition, because a unit investment trust (“UIT”) does not have a board or investment adviser, the rule requires a UIT’s trustee or depositor to determine fair value in good faith.

The rule is “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.” This designation would be subject to the following additional requirements:

  • Board oversight of the valuation designee, including periodic and prompt reporting to the board addressing specified matters; and
  • Specification of responsibilities and reasonable segregation (from portfolio management) of duties among the designee’s personnel;

Recordkeeping Rule 31a-4

In a change from the proposed rule, rather than requiring the maintenance of specific records as part of Rule 2a-5, the SEC opted instead to adopt a separate rule – Rule 31a-4 – to contain recordkeeping requirements associated with Rule 2a-5. Rule 31a-4 will require, substantially as proposed as part of rule 2a-5, funds or their advisers to maintain appropriate documentation to support fair value determinations. In addition, rule 31a-4 provides that, in cases where the board has designated the performance of fair value determinations to a valuation designee, the reports and other information provided to the board must include a specified list of the investments or investment types for which the valuation designee has been designated. By moving the recordkeeping requirements to a separate rule, the SEC addressed concerns that a recordkeeping failure alone could be deemed a failure to determine fair value in good faith.

Rescission of Prior SEC Guidance

With this more modernized valuation approach, the SEC also rescinded two releases, Accounting Series Release 113 and Accounting Series Release 118, which were published in October 1969 and December 1970, respectively, and represent the most recent comprehensive guidance provided by the SEC on how to determine fair value for restricted securities. In addition, certain staff letters and other staff guidance addressing fund valuation matters will be rescinded or withdrawn.

Effective Date

Rule 2a-5 will be effective 60 days after publication in the Federal Register. The SEC adopted an 18-month transition period beginning from the effective date for both Rule 2a-5 and the associated new recordkeeping requirements to provide time for funds and their valuation designees to come into compliance with the rule. Rescissions of all relevant SEC and staff guidance also would occur at that time.

 

 The full text of the rule is available at https://www.sec.gov/rules/final/2020/ic-34128.pdf

 

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