A 50-Year Vintage: Great for wines, but not valuation (Opinion)

VRC supports the SEC's Proposed Rule 2a-5 to modernize asset valuation guidance

By: Paul Balynsky | John Czapla

As the clock ticks down to the close of the SEC’s comment period for its April proposal, “Good Faith Determinations of Fair Value,” we believe it prudent to recap and opine on the proposed steps the Commission is taking toward modernizing fund valuation guidance.

A Brief Recap of Proposed Rule 2a-5: Fair Value Obligations

The last time the SEC published guidance on fund valuation practices was approximately 50 years ago in 1969 and 1970. The Commission acknowledged that financial markets have grown increasingly sophisticated since 1970 and that much more information is readily available. The establishment of Sarbanes-Oxley, the adoption of compliance rules, and the codification of FASB’s ASC 820 have influenced the SEC to revisit their position on investment company valuations.

The proposed rule maintains a funds’ board of directors responsibility for valuation oversight and a required documentation plan. It also allows the board to delegate the valuation process and responsibilities to its investment advisor. The proposal continues to emphasize that boards will still need to fulfill its duty to identify, monitor, and manage potential conflicts of interest when involving third-party valuation advisors or other service providers in delivering fund valuation analyses.

SEC Proposes Rule Modernizing Fund Valuation Guidance

SEC Proposes Rule Modernizing Fund Valuation Guidance

You can read our original, more complete overview of SEC Proposed Rule 2-a5, which provides the general requirements addressed within the proposal.

+ Read Our May 2020 Alert Here

The proposal continues to emphasize that boards will still need to fulfill its duty to identify, monitor, and manage potential conflicts of interest when involving third-party valuation advisors.

Rules Catching Up With Reality

The Commission’s approach to this proposal was not made in haste. While that statement seems to lend itself well to sarcasm, it is a well-intended remark. In acknowledging the progress of the financial markets and the evolution in the availability of data, it seems clear that the proposal was borne out of SEC outreach and consideration for both Wall Street advisors and Main Street investors.

Even with quintagenarian guidance in place, fund advisers and their boards have found ways to adapt and apply their years of practical expertise while also leaning on the professional chops of third-party valuation providers for meaningful support. (Assuming the advisors and the board work with an independent provider who has a track record in delivering transparent, objective, and practical opinions that satisfy regulators and give investors’ confidence.) But, of course, there’s always room for process improvement, and the fund community has undoubtedly been clamoring for consistency and guidance clarity around the execution of valuation-related activities.

In our review of the proposal as stakeholders in its eventual adaption and adoption, we find ourselves applauding the Commission for reinforcing our professional conviction: determining the value of a hard-to-value asset is a complex process, which requires experience, independence, and professional care.

Evolutionary, But Not Revolutionary

From a regulatory angle, the proposed rule and its requirements are not fraught with controversy, nor do the details include new or unique concepts that will necessitate significant readiness initiatives to adopt and implement the guidance. In our observation, we believe the proposal will enhance awareness of some of the following requirements and best practices:

  • Fund boards are tasked with providing the important safeguard of oversight of fair value determinations. Part of this oversight includes ensuring the fund maintains comprehensive fair value policies, procedures, reporting, and recordkeeping requirements that are periodically reviewed for relevancy.
  • Boards are permitted to delegate the determination of investment fair values to an independent adviser, which would make more efficient use of the boards’ time and expertise.
  • If a market quotation is not considered “readily available” the holding’s value must be fair valued as determined in good faith by the board. This may require the consideration of additional inputs by a qualified, experienced, independent valuation adviser.

Admittedly, VRC is a professional valuation and advisory services firm. Our Portfolio Valuation Practice Group is regularly engaged by over 3,000 fund advisors to value over 5,000 complex investments, thinly traded securities, illiquid assets, and non-public investments since the practice group’s inception in 2004. As such, we do offer a unique yet objective perspective on the topic.

Even with quintagenarian guidance in place, advisers have adapted their practical expertise while leaning on the professional chops of valuation providers for meaningful support.

Fine Tuning

For all of the positive attributes we see in the proposed rule, however, we also see opportunities for clarification within areas that would benefit from more attention to detail and further listening sessions between the SEC and responding stakeholders.

For instance, the proposal references various actors and fair value concepts that should be better defined to understand whether they are truly harmonized with existing FASB, PCAOB, or other standard-setting and rule-maker guidance.

The proposal also prescribes the advanced selection of valuation methodologies that are deemed appropriate to value a particular asset before the fund has invested in the asset. There will be investments where such an approach is not feasible. If a fund is limited in its investment opportunities by methodologies expressly disclosed in its policy, it is now made less flexible and may become less desirable to an investor.

There’s No Time Like the Present

The SEC’s timing in announcing proposed Rule 2a-5 comes when an emphasis on valuation in the wake of market disruption by the novel coronavirus has never been more important. An in-depth review of virus-related market events coupled with an examination of their internal fair value policies, procedures, reporting, and recordkeeping related to those proposed under Rule 2a-5 may serve fund advisers and their boards well. Doing so not only confirms the incorporation of best practices to prepare for the potential adoption of Rule 2a-5, but it also can provide comfort to investors that the fund will be prepared for the next significant market shock.

In general, VRC agrees that the SEC is taking the appropriate steps toward aligning guidance and best practices for fair value methods, and we applaud their effort. We look forward to working with other stakeholders and the SEC in refining and bringing about appropriate change and guidance. We anticipate that if the SEC moves toward the official adoption of the rule, a one-year implementation period will follow, making it likely that some version of the proposal will become effective in late 2021 or early 2022.

We welcome you to share your comments and opinions on proposed Rule 2a-5 or your questions about your firm’s existing valuation policy with our authors, John Czapla and Paul Balynsky.