When funds estimate the value of an asset, they have to follow certain rules. Simply put, the fund must use fair value estimations to determine how much something is worth, using good-faith methodologies that are clearly documented and repeatable. It’s not just good policy — it’s a requirement. Under the fair value rule, also called Rule 2a-5, the SEC requires funds to show their work and prove that their estimates are done in good faith. With this information, fund board members can better understand their duties and responsibilities for compliance with this rule.
What Is SEC Rule 2a-5?
Determining fair value of an asset can be tricky, especially for modern investments. There are a variety of tools that companies use to estimate the value of assets, and they do not always come to the same conclusion. Subjective assessments may be done in good faith, but they aren’t always accurate.
To minimize the risk that investors take when they invest in funds, the SEC proposed Rule 2a-5. Under its final adoption, this rule requires fund boards to take certain steps to assess fair value in good faith. The rule aims to set standards for valuation practices that are transparent and increase board accountability. It also helps address rising valuation challenges in a complex market.
Who Does SEC Rule 2a-5 Apply To?
SEC Rule 2a-5 applies to any registered investment company or business development company, including mutual funds and ETFs. The rule increases oversight requirements from the organization and its advisers. Specifically, the fund board has to maintain a higher level of oversight over the fund’s fair value methodology, to ensure that the determination is made consistently and in good faith. The guidelines extend to the fund’s valuation designee, if the board chooses to appoint one, as well as fund administrators and compliance officers. In order to ensure compliance with the rule, funds must delegate specific roles to relevant parties, with clear documentation outlining individual or group responsibilities, per Rule 38a-1.
Key Components of Rule 2a-5
When creating a fair value determination, fund boards or valuation designees should consider how to fulfill these components:
- Assess Valuation Risk: The fund must evaluate possible risks to the valuation, such as asset liquidity or market instability.
- Establish and Apply Fair Value Methodologies: The fund must select fair value methodologies that are appropriate to the asset type. For example, a fund might choose the market approach when there are plenty of assets for comparison, or the income approach for a derivative security.
- Test Fair Value Methodologies: Since valuation challenges often come from the choice of methodology, funds should regularly test the value of the asset based on the method to validate it and confirm accuracy of the estimation.
- Oversee Pricing Services: Some third-party companies offer pricing services. If a fund opts for these services, they should demonstrate their vetting process to ensure data integrity.
Compliant funds will have a set of written policies and procedures and keep records of fair value determinations for a minimum of six years, per Rule 31a-4.
Board Oversight and the Valuation Designee
If the fund board decides that estimating a fair valuation is outside the board’s expertise, it may appoint a valuation designee. The designee must have a fiduciary duty to the fund, such as the fund’s investment adviser, and report directly to the board. The board maintains numerous responsibilities, including:
- Selecting and approving the designee
- Overseeing valuations and reviewing regular reports
- Considering changes to the valuation methodology
The designee must provide quarterly reports to the board with detailed information about valuations. While the designee has fiduciary duty, the board retains ultimate responsibility for the accuracy and fairness of the valuation, per Rule 38a-1.
Updated Compliance and Framework
Although guidance concerning fair value estimations has been issued since the passage of the Investment Company Act of 1940, it was decades ago and did not account for significant changes to the nature of funds. The SEC determined that its amendments in 1969 and 1970 lacked clarity and relevance to the modern market, justifying new guidance.
The new rule formalizes practices that many were already following, but institutes a higher level of rigor and accountability. Specifically, the rule clarifies responsibilities of the board and its advisers, mandates written policies and valuation testing, and requires clear documentation of the use and methodologies of third-party pricing services. The final rule’s deemed execution date was March 8, 2021, but funds had until September 2022 to comply. During this time, funds were expected to update their systems to prove compliance.
Best Practices for Complying with Rule 2a-5
When estimating value for assets like derivatives securities, funds must follow the SEC final rule on Good Faith Determinations of Fair Value. For optimal compliance processes, funds should consider these best practices:
- Appoint a valuation designee with experience handling the fund.
- Formalize risk assessment and testing processes.
- Document decisions and sources from pricing services.
- Use technology to centralize the workflow, maintain an audit trail, and support reporting.
DFIN paves a clear path to compliance with a suite of solutions that streamline data collection and processing, to ensure that funds have compliant workflows and regulation-ready disclosures. Our advisory services provide expert support for various concerns, including complex asset valuations. To learn more about our compliance software, contact us to request a demo.