Viewpoints on the SEC’s Final Valuation Rule

In December, the SEC adopted a new rule under the 1940 Act to address valuation practices and the role of fund boards with respect to the fair value of the investments of mutual funds and BDCs. The rule provides requirements for determining fair value in good faith for purposes of the 1940 Act, including assessing and managing material risks associated with fair value determinations;  selecting, applying, and testing fair value methodologies; and overseeing and evaluating any pricing services used. The rule permits a fund’s board to designate certain parties to perform the fair value determinations, who will then carry out these functions for some or all of the fund’s investments. This designation will be subject to board oversight and certain reporting and other requirements designed to facilitate the board’s ability effectively to oversee this party’s fair value determinations. The rule also defines when market quotations are readily available under the 1940 Act. The SEC also adopted a separate rule providing the recordkeeping requirements that will be associated with fair value determinations and rescinded previously issued guidance on the role of the board of directors in determining fair value and the accounting and auditing of fund investments. The text of the rule is available here: Below are some key legal and other perspectives on the final rule.

“Readily Available” Market Quotations:  Lawyers at Simpson Thacher in their client alert on the final rule note that they have been particularly interested to see how the final valuation rule defines “readily available” market quotations and addresses the prompt board notification requirement for certain valuation issues. They noted that the SEC observed concerns that the definition of readily available market quotations could prevent funds from engaging in cross trades of Level 2 securities, including certain fixed income securities, if this concept in Rule 17a-7 were interpreted in accordance with the Rule 2a-5 definition. The Simpson lawyers wrote that in lieu of addressing this concern, the SEC instead provided an interpretation that the definition of readily available market quotations under Rule 2a-5 will apply in all contexts under the 1940 Act, including Rule 17a-7. “The SEC’s release recognizes that some funds will need to conform their practices under Rule 17a-7 to the extent certain securities may no longer be deemed to have readily available market quotations under the new definition and, thus, could not be traded in reliance on Rule 17a-7.”  They also note that the adopting release further states that the staff is currently reviewing staff letters on this topic to determine whether any should be withdrawn, and that the consideration of potential revisions to Rule 17a-7 is on the rulemaking agenda.

Fair Value Policies and Procedures.  Lawyers from Ropes & Gray note that advisers and funds may still need to consider changes to existing fair valuation policies and procedures in light of the new rule. “Although the Rule omits the specific provisions in the proposing release that would have separately required that a fund adopt written policies and procedures addressing the determination of fair value, funds and investment advisers will still need to consider changes to existing fair value policies and procedures that are reasonably designed to prevent violation of Rules 2a-5 and 31a-4. The Release notes that, because Rules 2a-5 and 31a-4 are new rules under the 1940 Act with new fair value determination requirements, and given the intrinsic relationship of the Rules to the board’s own statutory functions relating to valuation, the fair value policies and procedures must be approved by the board pursuant to Rule 38a-1.”

Ongoing Monitoring of Risks:  Lawyers at Sullivan Law note that  Rule 2a-5 does not specify the frequency for the required re-assessment of a fund’s valuation risks and the Adopting Release notes that determining the frequency of such assessment should take into account changes in fund investments, significant changes in a fund’s investment strategy or policies, market events, and other relevant factors. A fund’s board and the valuation designee should work together to establish the frequency of the periodic assessment of material valuation risks, they write.

Additionally, lawyers from Vedder Price review in detail board oversight responsibilities and reporting obligations described in the rule. Representatives from Deloitte recently discussed the rule in a Forum webinar available here. Additionally, Deloitte experts noted that the final rule could mean more formal risk assessment exercises, reporting and recordkeeping compliance requirements for the investment adviser and adviser staff.

The Forum will present a webinar with SEC staff on the final rule on February 3. Registration is available here.