The COVID-19 pandemic has muddied many waters. There is more uncertainty than ever about school, work, life in general. That’s why a recent proposal from the Securities and Exchange Commission was such a breath of fresh air, even though it’s entirely unrelated to the pandemic. In fact, the agency has been working on providing clarity on fair valuation – how fund boards or their advisers value some portfolio securities – for years. The proposal brings welcome clarity to a complex area of fund governance and, particularly as a mutual fund independent director, I’m grateful for the SEC’s initiative. Here’s the detail:
The SEC recently proposed new Rule 2a-5 under the Investment Company Act of 1940 (ICA) to modernize the framework surrounding the valuation of fund securities. Fund boards and advisers have long struggled with the appropriate division of labor between them when valuing fund securities. The ICA expressly assigns this duty to boards, yet most board members lack the technical expertise necessary to fair value the complex instruments often held today in fund portfolios. In practice, most boards have delegated their day-to-day responsibilities to their funds’ advisers, subject to oversight. But in the past, statements by the SEC and its staff have often served to confuse more than clarify the extent of boards’ specific responsibilities and, until recently, the agency has placed ever more responsibilities on mutual fund boards without sufficient regard to whether most board members had expertise in all the additional issues.
Proposed Rule 2a-5 is designed to remove this ambiguity and is a healthy reversal of the trend to “let the board deal with it” on complicated matters. Boards would clearly be permitted to delegate day-to-day valuation decisions to one or more advisers, but would retain ultimate responsibility – a framework no different than other instances where the SEC has permitted delegation. The board, however, is cautioned to “view oversight as an iterative process and seek to identify potential issues and opportunities to improve the fund’s fair value process.” [Release at II.B.1] Rather than taking a prescriptive approach to fair valuation determinations, the new rule requires a risk-based approach, appropriately emphasizing process, testing, and oversight.
The SEC’s proposal reflects the realities and complexities of modern investments and the adoption by many complexes of practical means of addressing the valuation challenges those investments present. It also recognizes the value of regulatory developments over the past several decades, such as the SEC’s compliance rule, the Sarbanes-Oxley Act, and FASB pronouncements. But most importantly, it recognizes what can be achieved when the SEC staff listens to industry with an open mind and thoughtfully incorporates its learning into its regulatory agenda.