Good Faith Determinations of Fair Value: A Small Entity Compliance Guide

Feb. 26, 2021

This compliance guide [1] is divided into the following parts:

Introduction

On December 3, 2020, the Securities and Exchange Commission (the “Commission”) adopted new rule 2a-5 under the Investment Company Act of 1940 (the “Act”). The rule provides a framework for how boards of directors of registered investment companies and business development companies (collectively, “funds”) will determine the fair value of fund investments in good faith for purposes of the Act. The rule will permit boards to designate certain parties to perform the fund’s fair value determinations, subject to the board’s oversight and certain other conditions. The rule also defines when market quotations are “readily available” for purposes of the Act, the threshold for determining whether a fund must fair value an investment. The Commission also adopted new rule 31a-4, which provides the recordkeeping requirements associated with fair value determinations. Finally, the Commission is rescinding previously issued guidance on related issues, including previous guidance on the role of the board of directors in determining fair value and guidance on the accounting and auditing of fund investments.

Who is covered by rule 2a-5?

New rule 2a-5 applies to all registered investment companies and business development companies, regardless of their classification or sub-classification (e.g., open-end funds and closed-end funds), or their investment objectives or strategies (e.g., equity or fixed income; actively managed or tracking an index). The rule includes specific provisions related to the determination of the fair value of investments held by unit investment trusts (“UITs”).

What are the rule’s requirements for determining fair value in good faith?

The Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations are “readily available.” However, when a market quotation for a portfolio security is not readily available or if the investment is not a security, the Act requires the fund to use the investment’s fair value, as determined in good faith by the fund’s board. The new rule sets forth certain functions that must be performed to determine the fair value of the fund’s investments in good faith. Those functions include:

  1. Periodically assessing any material risks associated with the determination of the fair value of the fund’s investments, and managing those identified valuation risks.
  2. Establishing and applying fair value methodologies. This involves the selection and application of appropriate fair value methodologies along with periodically reviewing their appropriateness and accuracy of the methodologies selected and making any necessary changes or adjustments. This element also involves monitoring for circumstances that may necessitate the use of fair value.
  3. Testing fair value methodologies for appropriateness and accuracy. This requirement includes the identification of the testing methods to be used and the minimum frequency with which such testing methods are used, but does not require particular testing methods or a specific minimum frequency for the testing.
  4. Overseeing pricing services, if used, including establishing the process for approving, monitoring, and evaluating each pricing service used and for initiating price challenges as appropriate.

Who may perform the functions required to determine fair value in good faith?

Under the new rule, a board may choose to determine fair value in good faith for any or all fund investments by carrying out the required functions discussed above itself.

A board instead could choose to designate the performance of fair value determinations relating to any or all fund investments to a valuation designee, subject to the board’s oversight. The valuation designee generally will be the fund’s adviser. Funds may not designate the performance of fair value determinations to fund sub-advisers. The valuation designee of internally managed funds, which do not have an adviser, may be an officer or officers of the fund.

In addition, for UITs, which do not have a board or adviser, the trustee or depositor generally must perform the fair value functions discussed above.

If the board designates a valuation designee to perform fair value determinations, what additional requirements apply?

Board oversight. When the fund’s board designates a valuation designee to perform fair value determinations, the new rule requires oversight by the board of the performance of the valuation designee.

Periodic and prompt board reporting. The new rule requires the valuation designee to provide certain information regarding its performance of fair value determinations in either quarterly or annual written reports to the board. In addition, the valuation designee must provide prompt notice and reporting to the board on matters that materially affect the fair value of investments whose fair value is determined by the valuation designee. Such matters requiring prompt reporting may include, as examples, 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.

Specification of functions. The new rule requires the valuation designee to specify the titles of the persons responsible for determining the fair value of the designated investments, including by specifying the particular functions for which the persons identified are responsible.

In addition, in making fair value determinations under the new rule, the board or the valuation designee may obtain assistance from others, such as pricing services, fund administrators, sub-advisers, accountants, or counsel, in fulfilling its duties. The board or the valuation designee, using this assistance, must fulfill its responsibilities under the Act, the final rule, and other applicable rules under the Act. Where the board has designated a valuation designee to perform fair value determinations, the valuation designee remains responsible for that determination and may not designate or assign that responsibility to a third party.

What are the recordkeeping requirements associated with the new rule?

New rule 31a-4 contains the recordkeeping requirements associated with the new rule.

Rule 31a-4 requires funds or their advisers to maintain appropriate documentation to support fair value determinations. In addition, where the board has designated the performance of fair value determinations to a valuation designee, certain specified information must be maintained, including (a) the reports and other information provided to the board by the valuation designee relating to its performance of fair value determinations, and (b) a specified list of the investments or investment types for which the valuation designee has been designated. These records generally are required to be maintained for six years, the first two in an easily accessible place.

The fund will be required to maintain these records unless the board has designated the performance of fair value determinations to the fund’s investment adviser. In that case, the investment adviser will maintain the records.

What are “readily available market quotations” for purposes of the new rule?

Under the Act, if a market quotation is readily available for a portfolio security, that security must be valued at the market value. Conversely, if a market quotation is not readily available, a portfolio security must be fair valued as determined in good faith by the board.

The new rule provides that a market quotation is readily available for a security only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. This definition is consistent with the definition of a “level 1” input in the fair value hierarchy outlined in U.S. GAAP. A security therefore will be considered to have readily available market quotations if its value is determined solely by reference to these level 1 inputs. The new definition of readily available market quotations applies in all contexts under the Act and its rules, including rule 17a-7.

What prior Commission releases or staff guidance are being rescinded or withdrawn?

In view of the new rule’s modernized framework for fund valuation, the Commission will rescind two releases related to fund valuation, Accounting Series Release 113 (ASR 113) and Accounting Series Release 118 (ASR 118). In addition, certain Commission guidance, staff letters and other staff guidance addressing a board’s determination of fair value and other matters covered by the rules also will be withdrawn or rescinded, including the guidance on valuation and pricing services contained in the 2014 release adopting amendments to the regulation of money market funds.

Effective and compliance dates

The rule will be effective March 8, 2021. The Commission has set a compliance date of September 8, 2022 (eighteen months following the effective date) to give funds sufficient time to comply with the provisions of the rule. Boards may begin to comply with the new rule any time between the effective date of the rule and the compliance date, provided they do not rely on ASR 113 or 118 or related Commission or staff guidance.

Other resources

The adopting release can be found on the Commission’s website at https://www.sec.gov/rules/final/2020/ic-34128.pdf.

The proposing release can be found on the Commission’s website at https://www.sec.gov/rules/proposed/2020/ic-33845.pdf.

Contacting the Commission

The Commission’s Division of Investment Management is happy to assist small entities with questions regarding rule 2a-5. You may submit a question by email to IMOCC@sec.gov. Additionally, you may contact the Division of Investment Management’s Office of Chief Counsel at (202) 551-6825.

[1] This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a “small entity compliance guide” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended. The guide summarizes and explains rules and form amendments adopted by the Commission, but is not a substitute for any rule or form itself. Only the rule or form itself can provide complete and definitive information regarding its requirements.

Last Reviewed or Updated: June 12, 2024