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Risk-based governance and reporting

SEC looks for boards to focus on pricing when it matters most

On April 21, 2020, the US Securities and Exchange Commission (SEC) proposed Rule 2a-5 under the Investment Company Act of 1940 (1940 Act). The proposed rule is the culmination of years of SEC outreach and speculation designed to provide boards and investment advisers of registered investment companies with a consistent, modern approach to the determination of fair value. In this edition of the Mutual Fund Directors and Investment Advisers Digest, we explore key takeaways of the proposed rule and its potential impact on boards, advisers, and auditors.

Key takeaways and observations of proposed Rule 2a-5

In Rule 2a-5, the SEC proposes both a framework for determining fair value in good faith and provides for boards assignment of its responsibility for the execution of valuation-related activities to a fund’s investment adviser.

Required functions that must be performed include:

  • assessing and managing material risks associated with fair value determinations
  • establishing and applying fair value methodologies
  • testing (e.g. back-testing or calibration) fair value methodologies
  • evaluating any pricing services used
  • adopting and implementing certain written fair value policies and procedures
  • maintaining certain records

Under the proposed rule, and consistent with current practices, boards that assign the fair value determination to an adviser, will continue to provide oversight of the process. The proposed rule would require the adviser to provide the board, at least quarterly, a written report that includes the following:

  • an assessment of material valuation risks, including any material conflicts of interest
  • any material changes or deviations of established fair value methodologies
  • results of any testing of established fair value methodologies
  • an assessment of the adequacy of resources allocated to the fair value process
  • any material changes to the selection and oversight process for pricing services used, including all price overrides
  • any other requested information

The SEC explains that this information is intended to supplement the board’s oversight, not to replace it.

The impact of proposed Rule 2a-5

The timeline for Rule 2a-5

  1. Registrants, boards, auditors, and other interested stakeholders have until July 21, 2020, to provide their comments on the 50-plus questions posed by the SEC. 
  2. The staff has provided for a one-year transition period and would be effective one year following the publication of the final rule in the Federal Register.

Why now? Things have changed.

The SEC cites three significant regulatory developments since 1970 (the last time valuation guidance was issued by the SEC) as an impetus for the proposed rule:

  • The Sarbanes-Oxley Act of 2002 which established the Public Company Accounting Oversight Board (PCAOB)
  • The 2003 adoption of compliance rules under the 1940 Act and Investment Advisers Act (together, the Compliance rules)
  • The issuance and codification of fair value guidance ASC 820 in GAAP

Another contributing factor has been the increased level of board anxiety over the extent of their involvement in the valuation process and details since at least one high profile SEC enforcement action against fund directors in 2012 for failing to comply with their valuation responsibilities under the 1940 Act. As a result, boards have been questioning what level of detail, knowledge, and oversight they need to have to fulfill fair value responsibilities, while the universe of investments by funds has grown more complex. These factors have created tension and potentially even confusion by some boards on how to strike the right balance between oversight and management.

Synching up proposed Rule 2a-5 with current market practices

The SEC acknowledges that rarely are boards today directly involved in a fund’s day-to-day valuation tasks and therefore this proposal is consistent with modern approaches to fair value determination. Further, the adviser’s experience and expertise are typically better aligned to the requirements necessary to accurately and fairly value complex fund investments. However, the SEC also emphasizes the potential conflicts of interest that arise when the investment adviser is involved in the valuation process.

The delegation or “assignment” 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 17 editions of the Deloitte Fair Valuation Pricing Survey (the Surveys). In fact, the Surveys have also evidenced that many of the boards and fund complexes already have many elements of the proposed framework with respect to the role of the adviser in the fair value determinations process, assessing and managing risks (including conflicts of interest), and overseeing and evaluating pricing services.

Other potential impacts of proposed Rule 2a-5

Fair valuation in the context of recent events

Given the long-anticipated release of proposed valuation guidance, many were surprised to see the proposed rule released during our current health and economic crisis. However, given the recent market volatility and disruption caused by the COVID-19 pandemic unique learnings and experiences gained will provide opportunities to offer fresh insights and almost real-time feedback from commenters. Boards, advisers, and other stakeholders should ask themselves whether the requirements of this rule would have helped or hindered the fair value process during these recent times of market stress and disruption. Would your valuation processes and communications behave differently applying the proposed rule, and would they have ended up with a different result relative to the methodologies used and ultimate fair value determinations, or, would it largely have been the same but with added time and compliance burdens?

The SEC should be commended for tackling a difficult area that has not been modified significantly in more than 50 years and providing a more modern, consistent and flexible framework around valuation for boards, fund advisers, auditors and other key stakeholders. Commenters should recognize that this proposal has emerged during a trying period for all businesses, but it is intended to have a lasting impact, long beyond the COVID-19 pandemic.

Get in touch

Paul Kraft

US Mutual Fund & Investment Adviser practice leader
Deloitte & Touche LLP
+1 617 437 2175


Ryan J. Moore

Deloitte & Touche LLP
+1 703 251 1874


Katelyn Yorra

Senior manager
Deloitte & Touche LLP
+1 617 585 5905

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