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How Will the SEC Rule 2a-5 for Fair Valuation Affect Fund Governance?

SEC Rule 2a-5 spells out how investment fund boards may assign responsibility for fair value methods and testing

On April 21, the US Securities and Exchange Commission surprised many in the markets by suddenly issuing a new proposed rule, SEC Rule 2a-5, addressing how valuation should be performed and governed, after decades of only offering guidance at most on this topic.

What do compliance and valuation professionals need to know about following SEC Rule 2a-5?

The rule defines valuation functions, places responsibility for assigning fair valuations to securities and covers how valuation risks should be determined and tested. Valuation functions include risk-based views of pricing issues, assessing material risks, devising fair value methodologies, setting testing methods that are appropriate and accurate, setting processes for pricing services that include approvals, monitoring and evaluations, reviewing policies and procedures, and lastly, record-keeping that will pass muster under a third party’s evaluation.

The heart of the new rule, however, is valuation responsibilities. The rule lets directors of investment funds assign responsibility to fund advisors, which some see as a beneficial change because fund directors are not always in the best position to assess fair value of securities in their portfolio. Funds covered in 2a-5 include open-ended funds, mutual funds, closed-end funds, unit investment trusts and business development companies. Boards can assign responsibility for some of the tasks previously mentioned – material risks, fair value methods, managing pricing services, and record-keeping procedures – with an eye to market data analytics & reporting being the drivers for governance processes.

Oversight around 2a-5

According to Rule 2a-5, board oversight should not be passive, but boards may assign responsibility to sub-advisors. Rule 2a-5 refers back to a previous SEC rule, 38a-1, that requires fund directors to approve fair value policies and procedures. This can be interpreted to mean that boards have to set policies and procedures but can assign work for compliance with those policies and procedures to other parties.

In fact, there are several parts of Rules 2a-5 and 38a-1 that intersect, most notably concerning the role that a firm’s chief compliance officer (CCO) should play and whether a chief valuation officer (CVO), which would be a new role in corporate governance, should be established and filled. The CCO should be involved in policies and procedures, according to the SEC guidance issued along with the new rule 2a-5. In reality, CCOs have taken on significant oversight responsibility for many issues and are often already handling fair value and pricing issues. Rule 2a-5, if adopted, would specify and codify CCO responsibilities.

Decisions to be made

Although Rule 2a-5 stops short of mandating that firms have a CVO, funds will have to decide whether valuation responsibility should be assigned to the CCO or a dedicated, separate CVO role. If that responsibility stays with a CCO, it makes more sense for that person to be focused on ensuring that the valuation processes, procedures and testing are being followed and performed correctly, rather than determining if prices are correct. To take it a step further, these processes will heavily depend on the liquidity of the assets being priced, as well as the flexibility of market data systems and valuation methodologies when it comes to incorporating proxy methodologies for instruments. This is a topic all on its own, however, which we’ll be discussing in a future blog soon.

Boards’ assignment of fair value responsibility to advisors could lead them to designate a separate CVO. This designation would ensure transparency into fair valuation processes, and avoid potential conflicts, such as an incentive for portfolio managers to want a security to be valued higher or lower for a trading, investment or performance reason. Cases concerning valuation practices have typically involved portfolio managers or investment advisors – if they have cited firm boards, there usually was also a case involving managers or advisors already or at the same time.

In addition, designating a separate CVO addresses the need for consistent approaches to “Fair Value Hierarchy” (levels 1, 2, and 3) and alignment with accounting guidelines such as FAS157 and IFRS13 – and can also manage the overlap between fair value governance on the buy-side and IPV and valuation control processes on the sell-side of a firm.

Going back to the ’40 Act rules that govern investment funds in the US, fund boards were given responsibility for fair value determinations. Fund boards often appoint fair value committees to do this work. The SEC’s proposed Rule 2a-5 recognizes that boards may assign responsibility for valuation, and could end up enabling the original ’40 Act valuation guidance to work as it should or as it was intended.

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