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Risk-based governance and reporting

SEC adopts framework for fund valuation practices

On December 3, 2020, the US Securities and Exchange Commission (SEC) adopted rule 2a-5 and rule 31a-4 under the Investment Company Act of 1940 (1940 Act). As adopted, the final rules seek to provide a common fund valuation framework across all fund groups, including business development companies. While confirming that a fund’s board can make fair value determinations itself, rule 2a-5 also permits a board to designate such determination to a valuation designee, primarily the investment adviser, and fulfill its statutory responsibilities through active oversight.

Throughout the 210-page adopting release, the SEC discussed their deliberation of more than 60 industry comment letters, making thoughtful observations, rebuttals, and, in some cases, agreement that resulted in changes to the final rule. Two notable industry comments that were not changed by the SEC were the definition of a “readily available market quote” (effectively scoping in all level 2 and 3 securities into the rule), and the SEC did not think that it was appropriate to recast rule 2a-5 as a safe harbor. While we believe that the final framework for fund valuation practices aligns with several practices today, we anticipate that many fund groups will have a heavy lift to comply with the rules. No doubt, certain formalities and board responsibilities introduced by the final rules will change the nature of valuation-related communications between boards and the investment advisers, as well as other industry stakeholders including, pricing services, the SEC, auditors, and fund administrators.

Mutual fund directors and investment advisers digest

Key takeaways and observations

In the SEC’s view, fair valuation in good faith with respect to the 1940 Act requires that boards:

  • Periodically assess and manage valuation risks associated with fair value determinations (including material conflicts of interest);
  • Establish and apply fair value methodologies;
  • Test fair value methodologies for appropriateness and accuracy;
  • Evaluate and oversee pricing services; and
  • Adopt and implement fair value policies and procedures under the compliance rule.

Boards can designate these activities to a valuation designee (primarily the investment adviser) so long as the board continues to provide active oversight of the valuation process.

Rule 2a-5, in situations where the board designates a valuation designee, requires quarterly valuation reporting.

Such quarterly reports in writing need to include:

  • Any reports or materials requested by the board related to the fair value of investments
  • A summary or description of material fair value matters that occurred in the prior quarter, including:
    • Any material changes in the assessment and management of material valuation risks, including any material changes in conflicts of interest
    • Any material changes or deviations of established fair value methodologies
    • Any material changes to or material events in the selection and oversight process for pricing services used

On an annual basis, the valuation designee must also provide the board in writing:

  • An assessment of the adequacy and effectiveness of the valuation designee’s process for determining the fair value of the designated portfolio of investments, including:
    • A summary of the results of the testing of fair value methodologies
    • An assessment of the adequacy of resources allocated to the process for determining fair value, including any material changes to the roles or functions of the person responsible for determining fair value

Under the final rule, the valuation designee will also be required to promptly notify the board at a time determined by the board, but no more than five business days after the designee becomes aware of material matters that may affect the fair value of the portfolio of investments, such as a significant deficiency or material weakness in the design or effectiveness of the valuation designee’s fair value determination process or material errors in the calculation of net asset value. The SEC’s final rule also clarified several definitional matters and rescinds previously issued guidance that has been rendered obsolete.

New and modified changes from SEC proposal

  • Establishment of rule 31a-4, moving recordkeeping requirements out of rule 2a-5
  • Removal of separate requirement for written policies and procedures from rule 2a-5, as deemed covered by rule 38a-1
  • Introduction of “valuation designee” terminology as opposed to “assign”
  • Modification of reporting requirements, including content and frequency enabling more board judgment and tailoring; specifically, changing the prompt notification requirement from three days to a max of five days, with 20 days to make a determination of a material matter
  • Specific guidance on board oversight particularly around obligation toward conflicts of interest and regular engagement
  • Eighteen-month transition period (as opposed to a one-year transition period in the proposal) following the effective date of the final rule

Impacts on key industry stakeholders

Syncing up the final rule with current market practices

The designation model to the fund’s investment adviser is something we’ve seen evolve over time through the lens of data and trends captured in the 18 editions of the Deloitte Fair Valuation Pricing Survey (the Surveys). With more than 100 fund groups participating in the 18th edition, we continue to obtain valuable insights into emerging, maturing, and industry valuation practices.

In fact, the Surveys have evidenced that boards and fund groups already have some of the elements of the designation framework with respect to the role of the investment adviser in determining fair valuation, assessing and managing risks, and overseeing and evaluating pricing services.

However, gaps in practice exist across fund groups that will need to be addressed. The flexibility and judgment once afforded to the valuation policies and procedures now requires specific mapping back to rule 2a-5.

The final rule does mirror some of the emerging, maturing, and industry trends already in place today:

  • Boards continue to play an important role in identifying and managing the fund’s valuation risks.
  • Some boards meet with the fund’s chief risk officer or members of the risk committee on a periodic basis to discuss the valuation of the portfolio securities as part of the assessment and management of previously identified risks.
  • Some boards noted that they identified conflicts of interest as a risk item in writing with a description of procedures to address it.
  • Many boards already periodically review the appropriateness and accuracy of the methodologies used in valuing securities and make any necessary adjustments.
  • Some boards focus on mitigating potential conflicts of interest with the investment adviser and, to a lesser extent, conflicts of interest of other parties.

Key survey observations:

  • Sixty-four percent of boards assess and refine the format, content, and frequency of the reports generated from a valuation dashboard.
  • Twenty-eight percent of survey participants have determined today what a “material” valuation risk is.
  • Eleven percent have put in writing the valuation risks for each asset class they manage.
  • Sixty-nine percent described the risks they have identified as “high-level risks” made up of five or fewer risks.

Looking ahead

The SEC tackled a difficult area that has not been modified significantly in more than 50 years with an objective of providing a more modern, consistent, and flexible framework around valuation for boards, investment advisers, auditors, and other key stakeholders. All stakeholders should recognize that these rules have emerged during a trying period for all, but are intended to have a lasting impact.

Boards and investment advisers now have a fresh opportunity to identify valuation risks and consider how to manage them. In doing so, they can take what they have learned and reassess whether new procedures should be developed, or existing processes modified to improve their identification and response to similar challenges in the future.

The final rule will be effective 60 days after publication in the Federal Register. Once the final rule becomes effective, a fund may voluntarily comply with the rule, as well as the associated new recordkeeping requirements, in advance of the 18-month transition period.

Ninety-nine percent of survey participants reported the use of summarized reporting or KVIs, and 46% reported the use of valuation risk dashboards.

Get in touch

Paul Kraft
Partner
US Mutual Fund & Investment Adviser practice leader
Deloitte & Touche LLP
+1 617 437 2175
Ryan J. Moore
Partner
Deloitte & Touche LLP
+1 703 251 1874
Katelyn Yorra
Senior manager
Deloitte & Touche LLP
+1 617 585 5905

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