On December 3, 2020, the Securities and Exchange Commission announced the approval of new Rules 2a-5 and 31a-4 under the Investment Company Act of 1940, thus providing the first major guidance on valuation to fund boards since 1970. Rules 2a-5 and 31a-4 will become effective 60 days after publication in the Federal Register and will have a compliance date of 18 months following the effective date. Early adoption after the effective date is permitted under certain conditions.
Rule 2a-5 largely codifies existing practices that have developed alongside other significant rulemaking, including Sarbanes-Oxley in 2002, the compliance rules of the Investment Company and Investment Advisers Acts in 2003, and FASB’s codification of ASC Topic 820 in 2006 and 2009. While not departing significantly from existing approaches to valuation, the Rule will require a significant effort on the part of funds in determining necessary changes to existing roles, responsibilities, policies, and reporting.
Rule 2a-5 leverages GAAP and the compliance rules in its implementation, borrowing, for example, the categories for valuation methodologies from ASC 820 (market approach, income approach, and cost approach) and requiring that funds’ 38a-1 compliance programs capture certain of its requirements. The Rule also rescinds ASR 113 and ASR 118 in their entirety, along with rescinding certain other prior valuation guidance.
While fund boards are currently responsible for the good faith determination of the fair value of securities, Rule 2a-5 acknowledges the degree to which many boards rely on investment advisors in reaching such determinations, allowing boards to formally “designate” certain responsibilities to a “valuation designee,” typically the fund’s advisor or an officer (in the case of internally managed funds). Notably, the valuation designee may not be a sub-advisor or fund administrator. However, the board or its designee may seek such parties’ assistance as they deem appropriate, with the understanding that such assistance does not amount to a further delegation of ultimate responsibility.
Regardless of such designations of responsibility, Rule 2a-5 requires boards to continue to assess and manage material risks, including the use of and source of unobservable inputs into valuations, the proportion of the fund’s investments and returns that are derived from investments fair valued in good faith, and risks introduced by service providers, to name a few.
Newly adopted Rule 31a-4 will require maintenance of appropriate documentation to support fair value determinations and, where applicable, documentation related to the designation of the valuation designee.
Rule 2a-5 requires that boards or advisors select, apply, and test fair value methodologies, as well as formalizes the oversight and evaluation of pricing services. Testing methods will need to be determined, and frequency of testing identified, with results and other related information forming the basis for quarterly reports to the board.
Foreside’s fund CCOs will be tasked with updating compliance programs and/or their due diligence reviews of advisor programs, depending upon the degree to which the board designates responsibilities to the advisor. Assuming the designation of responsibilities, advisor policies must specify the titles of the persons responsible for determining fair value and reasonably segregate the process of making fair value determinations from the portfolio management of the fund. Funds may wish to take the opportunity to review the staffing and structure of existing board committees with similar mandates, such as valuation committees and those persons fulfilling the duties of the Liquidity Risk Management Program Administrator, to determine whether opportunities exist to harmonize committee responsibilities, procedures, or charters with any new obligations.