SEC Rule Proposal Governing Good Faith Determinations of Fair Value

IM Report SEC Rule Proposal Governing Good Faith Determinations of Fair Value Debbie A. Klis · May 16, 2020

Recently, the Securities and Exchange Commission (“SEC”) proposed a new regulatory framework under Rule 2a-5 of the Investment Company Act of 1940, as amended (the “40 Act”) to shed light on the role of the board of directors of a registered investment company or business development company (“Boards”) with respect to fund valuation.  Historically, Boards assign valuation using a blend of guidance from regulations and SEC staff positions.  Often, Boards struggle to interpret the patchwork of 50+ years of regulations to ascertain their responsibility.  The SEC acknowledged that the market of investments has grown substantially with complex assets, more asset classes and significantly higher volume of valuation data, including from third-party pricing services thus more linear guidance is needed.

Proposed Rule 2a-5 under the 40 Act would establish good faith requirements when determining the value of a fund’s investments and define when market quotations are in fact readily available and when fair valuation would not be required.  Boards could assign the determination of value to the fund’s investment adviser and other parties, subject to continued oversight by the Board and compliance with other conditions.  Specifically, proposed Rule 2a-5 would impose six requirements on a Board with respect to the good faith valuation for purposes of Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder:

  • Periodic assessment of material risks associated with determining fair value of fund investments (valuation risks);
  • Establishment and application of fair valuation methodologies, consistent with current accounting guidance for fair valuation and taking into account the fund’s valuation risks;
  • Testing of fair valuation methodologies;
  • Evaluation of pricing services, if used;
  • Adoption and implementation of written policies and procedures reasonably designed to achieve compliance with the four preceding requirements; and
  • Maintenance of specified records.

The SEC articulated certain high-level expectations regarding board oversight where the board assigns fair valuation responsibilities to an adviser: boards should be objective and approach this oversight with a skeptical view; effective oversight is not passive but rather involves continuous engagement; and boards should consider this oversight to be an iterative process of identifying issues and opportunities for improvement.

The SEC proposed a one-year transition period for proposed Rule 2a-5.  If adopted, proposed Rule 2a-5 would become effective one year following publication of the final rule in the Federal Register. Comments on the SEC’s proposal are due by July 21, 2020.

See Release No. IC-33845; File No. S7-07-20] RIN 3235-AM71 Good Faith Determinations of Fair Value at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf for additional detail.