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The new rule is the most comprehensive statement of mutual fund fair valuation obligations for nearly 50 years and is likely to have profound changes for fund boards advisors and pricing service providers.

The Securities and Exchange Commission has just proposed a new rule that would establish a new framework for fund valuation practices. The rule is designed to clarify how fund boards can satisfy their valuation obligations in light of market developments, including an increase in the variety of asset classes held by funds and an increase in both the volume and type of data used in valuation determinations.

A Special Report by Voltaire Advisors, June 2020 2020

SEC RULE 2A-5: IMPLICATIONS FOR FUNDS, ADVISERS & PRICING SERVICES


This Special Report considers these implications in detail. It complements our recent Webinar on the same topic.


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1 INTRODUCTION

This paper does not intend to summarize the substance of the proposed Rule 2a-5 (‘the Rule’) in detail - this has already been done comprehensively by a variety of lawyers. Rather we try to read between the lines of the SEC release and come up with some implications and ramifications for mutual fund boards, advisers and service providers in the event that the proposal is implemented.

The first point to highlight is that the key provision of the Rule - allowing the assignment of fair value determinations to advisers - essentially formalizes and endorses a process that most funds have already implemented. Despite the ’40 Act stating that the calculation of fair value was a responsibility of the board and was non-delegable, in the real world fund directors do not have sufficient technical expertise or day-to-day involvement to be able to execute this task. Boards typically approve the methodologies, policies and procedures but allow the adviser or some other third party to perform the work.

This may explain the Commission's use of the term ‘assign’ to the process of allowing the fund adviser to assume this responsibility. This avoids a conflict with the previously stated ‘non-delegable’ nature of the boards duties and seems to imply that the statutory obligation remains with boards even when fair value determinations have been assigned to another party. The proposal does state that full compliance with Rule 2a-5 would, in the opinion of the SEC, satisfy these board obligations. However, it does not make clear what level of responsibility and/or liability now resides with the assignee. It is likely that the comments on the proposal will pick up on this.

The stated aim of the proposal is to clarify and modernize the fund valuation process (last addressed in any extensive way 50 years ago) generally in light of the rapid evolution of markets and financial instruments since then, and specifically reflecting:

o Sarbanes-Oxley and the creation of the PCAOB;o The new compliance rules in the ’40 Act (38a-1), and; o The fair valuation definitions reflected in FASB Topic ASC 820

It might also be supposed - though unstated - that the Rule is designed to dampen the furorecreated amongst fund board members by some provisions in the money-market reforms of2014. A short section in this long release seemed to imply that directors needed to be muchmore deeply involved in valuation decisions that was previously thought. The Commissionsubsequently played this down, but it undoubtedly increased the confusion over the board’sperception of its role in the fund pricing process.

The proposal reiterates the stance originally taken in 1940 that portfolio investments must befair valued in good faith in the event that market quotations for the security are not ‘readilyavailable’. Usefully, there is an updated definition of these circumstances based on more recentregulatory developments. ‘Readily available market prices’ are defined in terms of a Level 11asset as described in FASB Topic 820 - i.e. an unadjusted quoted price in an active market forthe identical investment at the measurement date.

The Rule essentially formalizes and endorses a process that most funds have already implemented


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The release also states that this situation would not apply if a market price were ‘unreliable’ - i.e. needed some kind of adjustment to determine the true fair value as defined under GAAP.As opined in the money-market reforms, this proposal restates that evaluated prices and‘accommodation’ broker quotes are not, in of themselves, considered to be readily availablemarket prices. The Rule requires funds to establish criteria where market prices are notreliable, and fair valuation is therefore required.

Notably, though the Rule formally proposes that it’s adoption will rescind a raft of previous guidance on fund valuation, these provisions of the money-market release are not mentioned. Again, watch out for this amongst the requested comments.

In many ways the risk- and principles-based approach taken in the release is similar to that of the recent liquidity risk management rule (Rule 22e-4) and derivatives rule (Rule 18f-4). In both these releases nominated administrators are required to manage the programs, and in 2a-5, when valuation responsibility is assigned to the adviser they are required to specify “the titles of the persons responsible for determining the fair value of the assigned investments”. The Rule stops short of enshrining the concept of a Chief Valuation Officer.

Compliance with a statutory rule rather than staff guidance may, in the end, provide less room for interpretation rather than more.

Much is made of the principles-based nature of the Rule, and there are a number of areas where specificity is lacking allowing for some ‘wiggle room’ when it comes to implementation. Having said that, it was somewhat of a surprise that the Commission chose a ‘rule’ for this purpose, having previously intimated that we could expect updated ‘guidance’. Compliance with a statutory rule rather than staff guidance may, in the end, provide less room for interpretation rather than more.


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2 FAIR VALUATION FUNCTIONS

We (and the SEC) assume that the vast majority of fund boards will assign fair value determinations to their advisers (or sub-advisers), although this may be more of a challenge for smaller entities (see comments later).

Whoever takes responsibility for this process will have to perform the six ‘functions’ outlined below. Rather than discuss the detail of the functions as proposed in the Rule - again, this has been more than adequately dealt with by the fund lawyers - this section looks ‘under the hood’ at some of the key issues and uncertainties that arise from the release.

Material Risks

"periodically assess and manage the material risks associated with the valuations'"

What are these risks? The only one specifically noted is that of material conflicts of interest. Others referenced, but not necessarily required, are: the types of investments made; market shocks and dislocations; the use of unobservable inputs in the valuation (especially if these inputs are provided by the adviser); the proportion of portfolio securities that are fair valued and their contribution to the fund’s NAV; the reliance on service providers (and their reliance on other parties), and; the risk of inappropriate or inconsistent methods.

How often should they be assessed? Also not specified. What would be considered material in this context? No discussion on that.

In the spirit of principles-based regulation, the SEC leaves these decisions to the fund, and maintains that the choices will depend on circumstances of fund. This accepts that there is not ‘one size fits all’ solution, but in doing so, leaves a great deal of interpretation to the funds themselves. One thing is for sure, the referenced risks might not all be required, but it would be imprudent for a fund to fail to consider them at all.

Methodologies

'"Select, specify and apply appropriate fair value methodologies, inputs and assumptions per asset class. Periodically review and adjust if necessary"'

While recognizing that there are a variety of methodological approaches, and that they may produce a range of prices which can reasonably be adopted as fair value, the release requires that any chosen methodology be consistent with ASC Topic 820. It is also stated that a fair valuation approach must be selected prior to investing in a new asset.

This requirement assumes that all the relevant and appropriate methodology options will have been considered and there will be an onus to justify and explain why the selected one was chosen. It would be sensible for a fund to couch this justification in terms of consistency with ASC Topic 820 to make the connection clear and obvious.

Also, while required to consistently apply the chosen approach during its tenure, there is an acceptance that there may be circumstances where a change in methodology is justified and appropriate (likely based on test results - see below). Again, it would be prudent to ensure that any changes are fully explained and documented.


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Testing

"testing of the appropriateness and accuracy of the methodologies. Specify the testing methods to be used, and the frequency of the testing"

The principles-based approach comes into play again with this requirement. The Rule does not specify what testing would be appropriate nor how frequently it would be required. These would ‘depend on the circumstances if the fund’ - a common refrain throughout the proposing release.

The SEC does, however, provide some clues. Back testing and calibration are mentioned frequently in the proposal, so it would be judicious for a fund to assess whether these two techniques are relevant and applicable in each scenario.

For non-specialists, what are these tests? Back-testing essentially compares the fair valuation used by the fund to observed transactions or other market information. Significant differences, especially consistently over time, suggest an issue with the fair valuation approach.

Calibration considers the difference between the actual price the fund paid to acquire a security and that it would have received by the fund’s fair value methodology at the time of acquisition. Material differences here are another possible red flag against the approach.

In general, the more subjectivity and judgement involved in portfolio pricing, the more advisable it is to have a robust testing procedure.

In general, the more subjectivity and judgement involved in portfolio pricing, the more advisable it is to have a robust testing procedure.

Pricing Services

"establish a process for approval, monitoring and evaluating each service provider and criteria for initiating price challenges"

The use of pricing services is extremely common in the fund industry today, but largely developed after the last extensive treatment of fund pricing by the SEC in 1969 and 1970. They have gradually appeared on the regulatory radar screen with some Staff guidance since then, but the money-market reforms of 2014 were the first to address them in detail.

The Rule suggests some measures to oversee and evaluate any pricing services used in the fair valuation process. It recommends looking at the servicers: qualifications, history and experience; methods, inputs and assumptions; handling of price challenges; potential conflicts of interest, and; testing processes. It should also be remembered that one of the material risks identified was the dependency of a pricing service on others - ‘fourth party’ risks - so it would be sensible to also include that in any assessment.

A slightly cryptic comment in the material risks section also referenced ‘reliance on service providers that have more limited expertise in relevant asset classes’. This suggests that the SEC are well aware that some assurances from pricing service providers about their reliability did not hold up well during periods of market volatility, especially in 2008 and the most recent cycle of COVID-19 related disruption.


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It appears that in recent years the Commission have woken up to the mission-critical nature of pricing service providers in the investment company ecosystem. We have commented on this in past reports and speculated on how this might play out in the future. However, what seems assured is that, if adopted, the Rule will require a significant enhancement and ramp up of current due diligence efforts conducted by funds and/or advisers on their pricing services. The consequences of this for the providers themselves are addressed in a later section.

The price challenge requirement is also interesting. The Rule requires the establishment of objective criteria for when and how a price received from a service provider can and should be challenged. It does not say what these criteria should be other than suggesting differential thresholds. Reading between the lines, however, there is a clear presumption that there needs to be a documented process in place, and prices should not be challenged ‘on a whim’. This recognizes that price challenges from portfolio managers, and how they are dealt with by pricing services represent a clear potential for conflict of interest in the relationship.

The Commission has woken up to the mission-critical nature of pricing service providers in the investment company ecosystem

Policies and Procedures

"implement written policies and procedures designed ensure compliance with the Rule"

It is highly unlikely that current fair value policies and procedures meet the requirements of the new Rule and it is recommended that current documentation be reviewed and updated to reflect the new regulations.

Note also that, in the event that the fair valuation process is assigned to the adviser, then it is the adviser who needs to adopt and implement the policies and procedures. This is subject to approval by the fund board and ongoing oversight under Rule 38a-1. Whilst some advisers may already have valuation policies and procedures in place, as mentioned before, they are highly unlikely to be sufficient to satisfy the new Rule. It is strongly recommended that these are reviewed and updated for this purpose.

Recordkeeping

"documentation to support fair valuations made and the policies and procedures in place for five years"

In the proposing release the Commission pointedly remark that documentation of decisions is often the primary evidence that valuation is being done in accordance with the law. To reinforce the importance, they also observe that enforcement actions have previously been taken over the failure to adequately maintain such records.

There are two important points to note about this section of the Rule. First, the documentation needs to be kept by the fund, regardless of whether the fair valuation process was assigned to advisers or sub-advisers. This implies that detailed adviser records will need to be made available to the fund for Rule 2a-5 purposes, and the fund board will need to satisfy themselves that these records are sufficient to comply with the Rule.


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The second stipulation about record keeping is, in our view, a potential can of worms. It is proposed that the documentation needs to ‘be sufficient for a third party to verify the fair value determination’. This presumably applies to the whole of the five year period that the records need to be kept. Such a requirement is in line with work on valuation standards being rolled out by the AICPA and other industry bodies as outlined in our previous report on Evaluated Pricing.

The scale of this task should not be underestimated. Even for a relatively simple fixed income security, to enable a third party to replicate the valuation will require the recording of inputs such as contemporaneous yield curve information, terms and conditions of the bond and credit ratings, together with assumptions made about spreads and other current market conditions and evidence to back these up. For more complex securities, such as mortgage and asset backed bonds, the range of information required is even more onerous.


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3 IMPLICATIONS FOR FUND BOARDS

Assuming that the fund board assigns the responsibility for fair value determination to an investment adviser or advisers, as the new Rule allows, what will be the implications for the board? Some of the challenges were highlighted in the previous section, but we look at this in more detail here.

At first glance, this proposal may give fund boards a level of comfort with respect to their valuation obligations - especially after the confusion and concern that resulted from the 2014 money-market release. Rather than sift through decades of SEC releases, staff guidance, enforcement actions and no action letters, funds and their advisers can look to one place for their regulatory framework.

However, as with all principles-based rules, this proposal places the onus on fund directors to develop policies and procedures that reflect the facts and circumstances of their particular funds. It is very much the boards responsibility to get this process right - there is no stated cookie-cutter model to fall back on. Boards that assign fair valuation responsibilities to advisers will be under increased scrutiny to ensure that their policies and procedures are appropriate and effective, and that advisers are carrying out their assigned responsibilities as stated.

It is very much the boards responsibility to get this process right there is no stated cookie-cutter model to fall back on.

As already referenced, the Rule will almost certainly require funds to modify their current valuation policies and procedures to address the specific aspects of the adviser delegation and oversight requirements. In assigning their responsibilities to advisers, there will also be the need to work closely with these parties to re-evaluate their processes and strengthen their oversight model. The more advisers to whom responsibility is delegated, then the more onerous this process becomes. Funds with multiple managers and sub-advisers will have a series of different policies and procedures to develop and approve, and a series of different parties to subsequently oversee.

In addition, this will not be a one-off exercise. Boards are required to approach oversight of fair value determinations with a “skeptical and objective view”, and this process must be an ‘active’ one. Therefore, even if the board assigns its valuation responsibilities to an adviser, it will still find itself performing an important level of oversight over the operations under the proposed Rule. It is noteworthy that several recent enforcement actions against funds in relation to valuations have focused on ‘passive’ boards offering inadequate oversight and not challenging adviser actions.


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So, what should this ‘active oversight’ look like? The proposal recommends that boards should: ask questions and seek relevant information; request follow up information when appropriate; use an appropriate level of scrutiny relevant to the fund’s valuation risk; seek to identify potential conflicts of interest amongst advisers and their service providers, monitor such conflicts and take reasonable steps to manage them, and; probe the appropriateness of the adviser’s fair value processes, such as periodically reviewing the financial resources, technology, staff and expertise of the adviser, and the reasonableness of the adviser’s reliance on other fund service providers.

In practice, this means that the riskier the valuation processes of a fund, then the more scrutiny they will require from the board. For funds where fair valuation is assigned to an adviser, the Rule prescribes a set of reports that advisers need to provide to the board (see next section). The SEC make it clear, however, that this information is only a starting point and receipt of these statutory reports alone should not be seen as full compliance with the oversight obligation.

Boards should assess the usefulness of the content of these reports and determine what additional information is required to allow them to fulfil their oversight responsibilities. In this principles-based world, it is the choice of the individual boards to determine what this might be, but the SEC helpfully gives some ‘suggestions’:

Board Oversight of Fair Valuation

o Summaries of price challenges, price overrides and results of associated back-testing;o Specific calibration and back-testing data, including directional and differential data;o ‘Stale’ price reports;o Breaches of tolerances;o Narrative summaries or reports on pricing errors;o Due diligence reports on pricing services;o Auditor testing reports;o Numbers of securities fair valued and their proportion of the fund, and;o Number, materiality and background to securities where fair values are derived from

broker quotes.

As with all the ‘suggestions’ provided by the Commission in its releases and guidance, it would be prudent for a fund to have a solid and documented rationale for why such information was not requested if it is not considered relevant in a specific fund scenario.

Any board hoping that this revised Rule, and the ability to assign the grunt work to an adviser, would result in less information in meeting packages is sure to be disappointed. The ‘active oversight’ provisions suggest that the range and complexity of the data and reporting to be analyzed and reviewed will increase significantly. Directors will also have to be much more conversant with some of the technical aspects of the process, such as testing and due diligence, to make sense of the information given to them.


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4 IMPLICATIONS FOR INVESTMENT ADVISERS

The proposed Rule 2a-5 may indeed recognize and authorize the current reality of day-to-day fair valuation being conducted by the investment adviser, but, as may be deduced from the foregoing discussion, compliance with the release is not simply going to be a process of ‘business as usual’. We have already looked at the potential for increased oversight workload for fund boards, and investment advisers equally, should they accept the official ‘assignment’ of fair value determination, will experience a whole new environment of reporting, record keeping and transparency.

The Commission acknowledges this, stating that the Rule would differ from the current regulatory framework because “it would mandate more specific fair value practices, policies and procedures, reporting, and recordkeeping requirements and those requirements would be explicitly imposed on funds and performed by boards or advisers.”

As mentioned previously, it is not altogether clear what level of responsibility and legal liability lie with the assignee in this relationship. Outright malfeasance or gross negligence is one thing, but who takes the rap if things go wrong and mistakes are made? Is it the fault of the manager or the overseer? It will be important for this to be made clear in the policies and procedures agreed between the fund and the adviser, and we also expect a discussion on this in the comments on the proposal.

It is not altogether clear what level of responsibility and legal liability lie with the assignee in this relationship.

The six ‘functions’ that an adviser would be expected to adopt, and the implications of doing so, have already been covered. The Rule also provides a quite prescriptive set of requirements when it comes to the type and frequency of reporting demanded of advisers, in contrast with the principles-based guidance given to fund boards. This fall into two categories:

Periodic Reporting - at least quarterly written assessment of ‘adequacy and effectiveness’ of fair valuation process including, at a minimum, statements on:

o material valuation risks;

o material changes to or material deviations from methodologies;

o testing results;

o adequacy of resources allocated to the fair valuation process;

o pricing services; and

o other information requested by the board.

Prompt Reporting - report in writing to the board, within three business days, any issues arising that do or could materially affect the fair valuation process.


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As we have already stated, it is highly probable that current valuation policies and procedures will have to be modified to comply with this new Rule, even if there is a limited impact on current practice. Advisers accepting the fair valuation assignment should review the reporting currently provided to boards and determine what additional resources would be required to comply with the new rule.

The prescriptive nature of these requirements has already been subject to criticism by a dissenting SEC Commissioner, and we can surely expect further comments on this during the review period. Opposition will doubtless focus on the costs of implementing and complying with the Rule and the likelihood of these costs being passed on to investors. How effective these objections will be, though, is moot. There was a similar level of dismay relating to the detailed ‘bucketing’ classifications in the 22e-4 Liquidity Rule, but these were only slightly watered down in the adopting release. In addition, the SEC has costed the likely impact of the Rule in their Economic Analysis, so they cannot be accused of failing to take this into account.

Mentioned previously, there is also an additional requirement for advisers to specify the individuals responsible for fair valuation and their functions. This is designed to “reasonably segregate the process of making fair value determinations from the portfolio management of the fund.” There is no discussion of what ‘reasonable segregation’ is, but the proposal does recognize that portfolio management can provide “important perspective and insight” and does not require a “firewall” between the pricing and fund management functions.

The prescriptive nature of these requirements has already been subject to criticism

While there have been recent enforcement actions relating to the undue influence of portfolio management on valuation, and it is clearly seen as an undesirable scenario, this is the first time a specific regulatory requirement has been proposed. Notably, some of the reporting requirements also specify transparency over the involvement of fund managers in any pricing decisions. Investment advisers will need to ensure that they have appropriate policies and procedures in place to ensure appropriate oversight of this.

The requirements for investment managers choosing to accept the assignment of fair valuation will be especially difficult for small and medium sized entities. There may not currently be an in-house reporting process capable of addressing all the components of the Rule (much of it may, for instance, be outsourced to a third party). Additionally, the nomination of a specific valuation responsibility, separate from portfolio management, might prove particularly challenging for smaller firms that do not have dedicated valuation personnel.

As with fund boards, an initial assessment of this proposal might have suggested that a clearer framework for valuation, and an acceptance of the role of the adviser in the process, would make life easier for fund managers. As can be inferred from this analysis, this is far from the case. Onerous new reporting and organizational requirements will place additional burdens and costs on advisers already dealing with liquidity and derivatives compliance.


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A final observation is that the Rule offers potential new areas for SEC enforcement. Advisers were clearly subject to regulatory oversight in many ways, but in relation to fair valuation they had always previously been able to hide behind the fact that it was the board’s legal obligation. If a fund board now formally assigns this responsibility to an adviser then do they no longer have anywhere to hide? This new liability will assuredly come into play when it comes to negotiation of new investment advisory contracts.


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5 IMPLICATIONS FOR PRICING SERVICES

The preceding discussion of the implications of Rule 2a-5 for fund boards and advisers (if assigned fair valuation responsibilities) has profound consequences for service providers involved in the process. We speculated on this in an earlier report on Evaluated Pricing and, with some of our hypothesis now being clarified, the conclusions reached then still have relevance. This is especially true of our comments on qualifications, standards, transparency and due diligence in pricing services.

It is important to note that in the Rule 2a-5 proposal the SEC staff reiterated its previous position that evaluated prices are not, by themselves, readily available market quotations and that broker-dealer "accommodation quotes" would also not be readily available market quotations. This means that data from pricing services and brokers will be subject to the provisions for fair value determination required under the Rule.

Evaluated prices are not, by themselves, readily available market quotations

In the six ‘functions’ specified in the Rule, the use of Pricing Services is explicitly highlighted. It is worthwhile looking closely at this element. The first point to note is that the Rule formalizes board responsibility for approval of pricing vendors by requiring the establishment of “a procedure for the approval, monitoring and evaluation of each pricing service provider”. Whilst leaving it up to the board to determine how to do this under their principles-based approach, the release helpfully provides a list of factors a fund should take into account during such an evaluation:

1. The qualifications, experience and history of the pricing service

This emphasizes the need to ensure that a chosen provider is up to the job. As previously discussed, under the material risks category the Commission has spotlighted the inadvisability of relying on third party service providers with limited expertise in an asset class. The specificity of this remark suggests that SEC staff have come across such scenarios in their research and outreach prior to the release. It is likely that pricing services will increasingly be called upon to justify themselves in this respect.

The reference to qualifications is also important. As we have pointed out in an earlier report (see Evaluated Bond Pricing: A New Paradigm?) there is no formal requirement for staff of a pricing service to have any kind of qualification or certification. Moves are afoot to change this, and the stipulation in the release may accelerate this development.

2. Valuation methods or techniques, inputs and assumptions used by the pricing service for different classes of holdings, and how they are affected as market conditions change

The Rule specifies that any fair valuation method must be consistent with the approach outlined in FASB Topic 820. The SEC recognize that, under this broad umbrella, there can be a number of different options that may be appropriate, and it is up to the fund to determine the best choice taking into account the circumstances of the fund. We have already recommended that fund boards ensure that they document and explain why a particular methodology was chosen and what other alternatives were considered.


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Pricing services can expect more questions on their chosen pricing methodology and will likely be expected to justify why this is the most appropriate for each asset class. There is also a strong focus on the consistent application of the chosen methodology.

However, the Rule does acknowledge that there may be circumstances where a change in methodology is appropriate. Our advice here is to ensure that any changes are fully explained and justified and the rationale for the alteration is fully transparent. The same advice would apply to a pricing service should it decide to change or modify a methodology, with the added recommendation to ensure that all their clients were properly warned and informed. This will allow fund boards to satisfy themselves that the fair valuation technique continues to meet their requirements.

Additionally, the discourse about material risks in the release particularly focused on the reliance on ‘unobservable inputs’, especially those derived from the adviser. This would equally apply to those kinds of inputs and assumptions (i.e. subjective and judgmental) applied by any pricing service relied upon by the adviser.

There is also specific mention of ‘fourth party’ risks. Many pricing services rely on other vendors and service providers for technology, analytics and crucial input data. The proposal requires that the contribution of these ‘fourth parties’ be subject to scrutiny in addition to the ‘third party’ services themselves. This will add a whole new level to the transparency required from pricing services in due diligence and reporting exercises.

Pricing services can expect more questions on their chosen pricing methodology

3. Pricing service’s process for considering price “challenges,” including how thepricing service incorporates information received from pricing challenges into itspricing information

Price challenges - where the valuation opinion of the fund or adviser differs from that of a service provider, and the vendor price is ‘challenged’ - are mentioned frequently in the proposed Rule, an indication that the SEC see’s this process as an area of concern. We have already discussed that whoever assumes responsibility for fair valuation determination is required to implement ‘objective’ criteria for when to initiate a price challenge from the user side.

This factor considers what happens when the challenge is received by the pricing service. What steps are taken to deal with the challenge? What responses are typically given? In particular, the scenario where a price challenge results in a modification of the valuation level is spotlighted. This situation, where information provided by the client results in a change in the price by the vendor, is an obvious area of possible manipulation or collusion of fair value and it is worthwhile paying extra attention to this. Pricing services should ensure that, if a valuation is changed as a result of a client price challenge, that this is fully explained and justified, and full transparency given to the circumstances of the adjustment.


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4. Pricing service’s potential conflicts of interest and the steps the pricingservice take to mitigate such conflicts

The potential conflict of interest associated with price challenges has just been noted. This is one example of where the desire of a pricing service to satisfy a paying client may result in their manipulation of the price level to suit that client. Another example is where price levels are adjusted gradually over time to avoid material impact on a fund NAV - so called ‘smoothing’. There are others.

To ensure that pricing services recognize these potential conflicts, and demonstrate that they take steps to mitigate them, it is recommended that vendors have written policies and procedures in place relating to interaction with clients. It is likely that funds and advisers will scrutinize these procedures and ask for evidence of them being implemented.

5. Testing processes used by the pricing service

As previously discussed, the Rule does not specify what methods or frequency of testing the SEC expect. Once again, this is left up to the fund to determine what is appropriate given their own particular circumstances.

In an earlier section of this report, however, the techniques of back-testing and calibration were defined, and we recount that these testing processes are mentioned repeatedly in the release. Given the importance attached to such methods by the Commission, and their expectation that advisers will use them in fair valuation determination, it would seem prudent for pricing services to also perform similar analysis insofar as they have the necessary data.

Supplementing these specific factors covered in the required functions for fair valuation, a number of other implications for pricing services arise in other parts of the proposal, many of which have already been raised in earlier sections of this report. These include:

o Policies and procedures - these are required to be approved by the fund board. Thoseof the adviser can be used in the event that fair valuation is assigned to them, but it islikely that funds and advisers will work together to implement mutually acceptable policies and procedures. Given the deep involvement of pricing services in the process, it is advisable that vendors have robust and consistent policies and procedures that align with those of the fund/adviser.

o Record keeping - funds are required to retain detailed records of their fair valuation processes and decisions for five years. In addition, as we have already highlighted, these records need to be sufficiently detailed for a third party to verify the valuation. Insofar as these fair valuations derive in a large part from pricing services, the onus for providing this data and documentation will fall on the vendor. Service providers should be prepared to provide much more depth on the methodologies, inputs and assumptions underlying pricing opinions.


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o Active oversight - fund boards are obliged to be vigorous in their oversight of the fairvaluation process, and not simply accept the reports and assurances supplied to them ona routine basis. Reliance on pricing providers is one of the factors boards need toscrutinize, and much of the additional information the Rule suggests boards requestrelate to pricing services. Vendors should be prepared for an increase in the frequencyand detail of questions from fund boards.

o Periodic adviser reporting - aside from the supplementary information that fund boardsrequire, advisers assuming fair valuation responsibility have a statutory requirement toprovide a detailed report to the board at a minimum quarterly frequency. This standardreport has a specific section on pricing services, together with reams of testing resultsand stats. Service providers should be prepared for regular requests for supporting datafrom advisers to help prepare these reports.

o Prompt reporting of issues - alongside the periodic reports, advisers are required topromptly (within three days) report to the board any issues arising that have, or mayhave had, a material impact on the fair valuation of the fund. The suggestion is thatthese issues will be unexpected valuation challenges, some of which may relate to pricingservices. The adviser will expect full involvement and co-operation from a pricing serviceshould such a scenario occur, and vendors should be fully prepared and resourced toparticipate in highly time critical ‘fire drill’ procedures in such cases.

It should be noted that the Rule also has implications for other types of fund service providers, such as brokers providing price quotes, and auditors. Much of this relates to the new PCAOB standards and guidance with which the proposals align. We covered this in our earlier report on Evaluated Bond Pricing.

In conclusion, the proposed Rule represents a profound change in the way that pricing services interact with funds and advisers in relation to the determination of fair value. Pricing vendors can expect significantly greater due diligence on their operations and methodologies at the outset of a relationship, and much more vigorous oversight and scrutiny during a contract. There is every likelihood that fund boards will be more involved in this process, even if the main point of interaction is with the adviser.

The levels of training, data, documentation, client service, recordkeeping and reportingrequired from pricing services will represent a paradigm shift for pricing vendors who mayneed to look carefully at their business models. We covered this extensively in our previousreport and see no reason to substantively change our conclusions following the release of theproposed Rule 2a-5.


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6 CONCLUSIONS

o The proposed Rule 2a-5 essentially ratifies much existing practice in the determination of fair valuation for funds and helps to clarify some recent concerns by fund boards about their obligations. However, there is still some uncertainty as to where ultimate liability lies.

o The release also provides a much more detailed definition of ‘readily available market prices’ in terms of FASB Topic 820, giving more transparency on when fair valuation is necessary.

o The frequently stated ‘principles-based’ nature of the proposal leaves a lot of the detailed decision making on fair valuation policies and procedures to individual funds and their advisers. This suggests that funds will have more flexibility to tailor their processes to their own circumstances.

o However, the fact that the SEC chose a rule for the purposes of updating fair valuation requirements, rather than updated staff guidance as was expected, may well serve to reduce the ‘wiggle room’ available.

o ‘Active oversight’ is required of fund boards, and the range and depth of information and analysis this will require should not be underestimated.

o For advisers to whom the responsibility for fair value determination is assigned, there will be a significant new reporting and recordkeeping burden adding to costs of compliance.

o Pricing service providers, who are deeply embedded into the fund pricing ecosystem, will also face increased levels of due diligence and ongoing scrutiny.

o One final thought. There is a strong presumption throughout the SEC proposal that fund boards will formally assign the responsibility for fair valuation to their advisers (since they are likely doing it anyway). Where would it leave everyone if advisers decided that with additional costs and uncertainty about ultimate liability, they would choose not to accept the assignment?

More information

For more information, detailed guidance and training on fund valuation, please inquire about our upcoming courses:

Fund Pricing Methods, Sources, Policies & Procedures

o Training for fund pricing operationso Essentials for fund boardso Essentials for fund counsel and CCO’s

We…• Provide bespoke advice to users

and service providers tasked with valuing and overseeing therisk of financial assets;

• Publish unique and acclaimedresearch and analysis into keyaspects of valuation risk, and;

• Organize important workshopsand briefings bringing togetherregulators, users and service providers of valuation data, analytics and models.

Special ists in Valuation Risk

VoltaireADVISORS

Common sense is not so Common.

To learn more about us or our service offering,

please contact us:

Voltaire Advisors 14 Wall Street

New York, NY 10005

Voltaire Advisors No.1 Poultry

London, EC2R 8JR

0800 677 1694

e: [email protected] w: www.voltaireadvisors.com


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