(Estimated reading time: 3 minutes)
The article in brief:
- The SEC has proposed a new rule that will update its fund valuation guidance for the first time in 50 years.
- Proposed Rule 2a-5 establishes a board’s responsibilities as it pertains to a fund’s determination of their investments “in good faith,” including their ability to delegate responsibility to their investment advisor.
- The SEC has opened a comment period on the matter until July 21, 2020.
The Securities and Exchange Commission has recently opened a comment period, now through July 21, 2020, for its newest proposal, “Good Faith Determinations of Fair Value.” Under the Investment Company Act of 1940 (the Act), proposed Rule 2a-5 would clarify and modernize how fund boards can satisfy their valuation obligations by establishing a framework that focuses on valuation processes, testing, and oversight and expressly permits the board to delegate investment valuation to an advisor. Currently, it is an industry best practice for a board to outsource valuations to independent third-parties so that the board can focus on performing their core oversight functions.
According to the April 21 announcement, the SEC believes updated guidance is needed due to “an increase in the variety of asset classes held by funds and an increase in both the volume and type of data used in valuation determinations.” Further, under the proposal, fund boards would also be allowed to assign their valuation role and responsibilities to fund advisors.
The last time the SEC published guidance on fund valuation practices was approximately 50 years ago in 1969 and 1970. The proposed revision has anecdotally been in process for upwards of twenty years as market participants have been seeking guidance from the country’s most influential financial markets regulator.
The Commission acknowledges that financial markets have grown increasingly sophisticated since 1970 and that much more information is readily available. Additionally, 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. Under their initial guidance, ASR 113 and ASR 118, the SEC noted that the board did not itself need to perform the steps necessary to calculate fair value and that the technical assistance received must be carefully reviewed to ascertain that the resulting values were indeed fair.
Proposed Rule 2a-5: Fair Value Obligations
The proposed rule maintains the board’s responsibility for valuation oversight and a required documentation plan; however, it allows the board to delegate the valuation process and responsibilities to their investment advisor. For the board to satisfy its statutory obligations, delegation to an advisor is subject to these general requirements:
- Assessment and Management of Valuation Risk. Periodically assessing and managing material risks associated with determining the fair value of the fund’s investments, including material conflicts of interest.
- Selection, Application, and Tests of Valuation Methodologies. Selecting, consistently applying, and testing appropriate valuation methods (consistent with ASC 820), while also taking into account the fund’s valuation risks.
- Provider Oversight. Approving, monitoring, and evaluating service providers and pricing, which would include consideration of qualifications and experience of the advisor.
- Documentation and Recordkeeping of Policies and Procedures. Adoption and implementation of written valuation policies and procedures, as well as documentation support of the valuation analyses.
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. To this point, it would seem to be advisable for the fund’s board to strongly consider a firm’s independent nature when selecting an advisor.
New board reporting requirements are also addressed within the proposal, directing the evaluation of the type, content, and frequency of valuation reports a board would expect to receive from its advisor. It also suggests that at least quarterly, the valuation report should be delivered to the board so it can assess a summary of:
- Valuation risks, including conflicts of interest
- Material changes to valuation methods
- Valuation method test results
- Roles of valuation professionals involved in the analysis
- Material process or pricing changes
- Any other board-requested materials
The proposed reporting requirements are intended to supplement the board’s oversight function, allowing it better opportunities to identify trends, exceptions, or performance outliers.
It is advisable for the fund’s board to strongly consider a firm’s independent nature when selecting an advisor.
“Readily Available,” Redefined
As it pertains to market quotes, the Act and the current rules do not adequately define the concept of “readily available.” In its proposal, the SEC would better define “readily available” to align with U.S. GAAP concepts found in ASC 820. As such, a market quotation would be defined “when it is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the valuation date.” It would also need to be considered reliable. If the quote needs adjustment or if additional inputs must be used to determine the security’s value, U.S. GAAP, and by extension Rule 2a-5, then considers the market quotation unreliable.
The fund boards that will see the most benefit in the adoption of the proposed rule are those overseeing funds with complex investments, thinly traded securities, illiquid assets, or non-public investments. As it is proposed, Rule 2a-5 does not change the market practices concerning valuation dramatically, and it may prove beneficial to boards of funds with both unique and standard valuation methodologies and circumstances. Since the SEC has now expressly permitted assignment of the determination of investment fair values, boards should strongly consider contacting a valuation specialist to assist in this vital role.
The SEC has opened a comment period until July 21, 2020. If the proposed rule is adopted, the SEC indicates they will allow a one-year transition period for funds and advisers to comply.
SEC Requires Third-Party Fairness Opinion Certificate for BDCs
The SEC, as a response COVID-19, provided temporary exemptions to BDCs to issue and sell senior securities if they are “unable to satisfy the asset coverage requirement under the Investment Company Act of 1940 (the Act) due to temporary mark-downs in the value of the loans to such portfolio companies.” This SEC order is in effect until 12/31/2020.
COVID-19 and the Impact on Private Equity
The COVID-19 market dislocation could be compared, not only to the Great Recession, but also—inversely—to the “irrational exuberance” of the dot-com era.
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