The Securities and Exchange Commission (SEC) passed a new set of rules in December 2020, dubbed Rule 2a-5, that will require investment management firms to place greater controls around the way they determine fair value for assets that lack readily available market prices.

The new SEC fair value rules will modernize guidelines that have stood unchanged for at least half a century. The original SEC fair value rules were first set out in the Investment Company Act of 1940 and last updated in 1969 / 1970. Those original rules require a fund’s board to determine fair value when market quotes are unavailable, but do not necessarily provide much detail on how to control valuation risk (particularly relative to newer regulations such as UCITS in Europe). By contrast, the newly proposed rules offer clarification on valuation risk, guidance on how the valuation function can be assigned to advisers, along with a broad range of updated reporting requirements.

The SEC published rule 2a-5 in the Federal Register on the 6^th of January 2021, with the rule due to become effective on the 8^th of March 2021. Investment companies (and their service providers) then have a transition period of 18 months to operationalize changes and ensure compliance before the new rules are enforceable.

Below, we detail some of the key areas targeted by the new rules:

Valuation Risks

Any market downturn tends to heighten awareness of liquidity and valuation risk. The recent Covid-related crisis was no different, as market volatility prompted difficult decisions in determining fair value for illiquid assets. The new rules proposed by the SEC are therefore very topical. With regards to valuation risk, the rules do not specify a methodology for controlling such risks, but do define factors that contribute, including:

• The types of investments held
• Potential market or sector shocks or dislocations
• The use of unobservable inputs in valuations
• The proportion of investments priced at fair value and their contribution to fund returns
• Third- and fourth-party risks (such as relying on service providers with limited expertise)
• The risk that methods for calculating fair value are inappropriate or not applied correctly

Fair Value Methodologies

As with valuation risk, the proposed rules are not overly prescriptive in mandating specific fair value methodologies. However, they do require that chosen methodologies be applied consistently and that funds specify key inputs and assumptions relevant to the valuation of each asset class, as well as methodologies applicable to any new investments that the fund intends to invest in. In response to industry comments, the new rules also clarify that fund boards, or advisers, can specify different methodologies for individual securities (or sub-classes within an asset class), and that applying methodologies consistently does not preclude the board (or valuation designee) from changing methodologies if circumstances necessitate. Part of that determination includes having a process in place to periodically review the appropriateness and accuracy of methodologies (which includes testing – detailed in the next section).

The proposal also suggests that fund boards (or advisers) monitor for circumstances that may necessitate use of fair value (for example, if a significant event occurs after market close). This requirement originally suggested that criteria be established up front to determine when market quotes are no longer deemed “reliable” and fair value techniques ought to be applied. However, this requirement was removed given that it was not deemed feasible to foresee all possible factors that would impact the ‘reliability’ of market quotes.

Testing Fair Value Methodologies

Under the proposed rule, a fund’s board will be required to identify both the testing methods used and frequency of testing employed to determine whether fair valuation techniques are accurate. Although the SEC has not mandated the use of any specific methodologies or testing frequencies, the regulator does note that “results of calibration and back-testing can be particularly useful in identifying trends.”

Equally, the SEC acknowledges that firms may have existing systems in place (such as price mastering technology) that can alert when prices have not changed (and may therefore be stale) or potential anomalies (such as price spikes) that may require further investigation.

Pricing Services

For thinly traded OTC securities and derivatives, the SEC recognizes that many funds are reliant on pricing services, and as such, proposes that fund boards (or advisers) maintain oversight and evaluation of those services.

To that end, the rule suggests that “the board or adviser establish a process for the approval, monitoring, and evaluation of each pricing service provider.” In doing so, they should consider the following factors:

1. Qualifications, experience, and history of the service
2. Valuation methods or techniques, inputs, and assumptions used
3. The quality of pricing information provided (and timing issues such as whether prices are generated to coincide with when the fund calculates its NAV)
4. Price challenge processes and how challenges are incorporated into pricing information;
5. Potential conflicts of interest and steps taken to mitigate them
6. Testing processes

The rule also suggests that a fund’s board or adviser should set out criteria for when they would instigate their own price challenge (should the valuation provided by the pricing service differ materially from their own).

Record Keeping

With regards to record-keeping requirements, the rules will require funds to keep records of fair value determinations for at least six years after the determination was made. These records include information relating to the methodologies applied, as well as assumptions and inputs considered. Equally, records need to be kept to demonstrate that fair value policies and procedures were in effect.

Reporting

The new rules permit fund boards to assign the valuation function to an adviser or ‘valuation designee.’ However, they do not permit delegation of ultimate responsibility for determining fair value. That means the board still needs to maintain oversight of the function, and as such, will require regular reports to be able to perform that function.

The new rules state that these reports should be made on both a quarterly and annual basis.

Quarterly reports are to include:

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

Annual Reports should include:

• Assessment of the adequacy and effectiveness of the designee’s process for determining fair value
• A summary of the results of testing fair value methodologies (including any material changes to the roles or functions of the persons responsible for the process)

Regarding specific data that ought to be included in reports to fund boards’, the SEC does not go so far as to detail requirements, but does give examples, including:

• Portfolio holdings whose price has changed outside of pre-determined ranges over time (otherwise known as price spikes)
• Reports regarding stale prices (also known as flats)
• Trends in the number of the fund’s portfolio holdings that received a fair value determination

How will SEC fair value rules impact data management?

The new SEC fair value rules will help encourage best practices when it comes to valuation control. Without being overly prescriptive on methodologies or other processes, they require organizations to have systems and controls in place to maintain close oversight of the valuation function. Some requirements point towards well-established solutions, such as price mastering, to ensure stale prices are not being used, pricing anomalies are investigated, methodologies tested, and an audit trail is kept of all relevant processes. Given that boards can assign duty of valuation to a designee, but need to maintain oversight of the function, tailored reporting is likely to be required to ensure they have enough information to carry out that supervisory role.

Also of interest is the fact that new rules on funds’ use of derivatives, which also have data management implications, will need to be implemented concurrently. For more information see our blog entry.