Proposed SEC Fair Value Rule 2a-5 2a-5 - May 2020...TALENT. TEAMWORK. RESULTS. Proposed SEC Fair Value Rule 2a-5 Implications for Funds, Boards and Service Providers Voltaire Advisors

Proposed SEC Fair Value Rule 2a-5IMPLICATIONS FOR FUNDS, BOARDS AND SERVICE PROVIDERS

WEBINAR – WEDNESDAY MAY 6TH – 10:00 ET

2

Agenda

Welcome Ian Blance | Managing Director, Voltaire Advisors

1005 - 1020 Legal & Compliance Obligations | Jay Baris, Partner, Sidley Austin

1020 - 1035 Implications for Fund Boards | Buddy Donohue, Independent Director, BNY Mellon Funds

1035 - 1045 Fund Operations & Service Provider Issues | Ian Blance, Voltaire Advisors

1045 - 1100 Audience Q&A

1100 Close of Webinar

3

Legal & Compliance Obligations

Jay BarisPartner Sidley Austin

TALENT. TEAMWORK. RESULTS.

Proposed SEC Fair Value Rule 2a-5

Implications for Funds, Boards and Service ProvidersVoltaire Advisors WebinarJay G. BarisSidley Austin LLP6 May [email protected]

• April 25, 2020 – SEC proposes Rule 2a-5 • Decades in the making, Rule 2a-5 would

• Establish a new, comprehensive principles-based framework for fair value determinations when a market quotation is not readily available– Section 2(a)(41)(B) of the 1940 Act defines “fair value” as a valuation “determined in good faith by the board of directors”

• Define “readily available” for purposes of the 1940 Act• Clarify role of fund directors, embracing a more traditional oversight role

– Directors can “assign” fair value determinations to a fund’s investment adviser and/or sub-adviser– Allocation or responsibilities subject to comprehensive oversight and reporting requirements

• Apply to open-end funds (mutual funds), closed-end funds and business development companies (BDCs)• Fair value determinations in good faith would require:

• Assessing and managing material risks associated with fair value determinations• Selecting, applying and testing fair value methodologies• Overseeing and evaluating pricing services• Adopting and implementing policies and procedures and maintain certain records

Proposed Rule 2a-5 – Good Faith Determinations of Fair Value

SIDLEY AUSTIN LLP 5

Introduction

• Rule 2a-5 would establish required functions to be performed to determine in good faith the fair value of a fund’s investments

• Determining valuation risks– Period assessment of material risks, including material conflicts of interests, associated with fair value determinations– Fair value risks include, among other things:

• The types of investments held or intended to be held by the fund• Potential market or sector shocks or dislocations• The extent to which each fair value methodology uses unobservable risks, particularly if the adviser provides the inputs• The proportion of the fund’s investments that are fair valued in good faith, and their contributions to the fund’s returns• Reliance on service providers that have limited expertise in asset classes; fair valuation methodologies that rely on inputs provided

service providers; and extent to which third party providers rely on others• The risk that methods for determining and calculating fair value are appropriate or that they are not being applied consistently or

correctly


SIDLEY AUSTIN LLP 6

Requirements for determining fair value

• Rule 2a-5 would establish required functions to be performed to determine in good faith the fair value of a fund’s investments

• Fair value methodologies– A good faith fair value determination would require selecting and applying in a consistent manner appropriate methodologies, including

specifying:• Key inputs and assumptions specific to each asset class or holding• Methodologies that will apply to new types of investments

– Methodologies must be consistently applied– Appropriate fair value ranges vary, depending on the facts and circumstances– Board or adviser may change methodology when appropriate

• Testing fair value methods– A fund must test the appropriateness and accuracy of fair value methodologies– Funds must identify:

• Testing method to be used• Minimum frequency of testing

– No specified requirement for nature and frequency of testing


SIDLEY AUSTIN LLP 7


• Pricing services– Pricing services typically provide information on evaluated prices, matrix prices, price opinions or similar pricing estimates to help

determine fair value– Rule 2a-5 would require the board (or the adviser) to establish a process for approval, monitoring and evaluating each service

provider– Factors to consider include:

• The qualifications, experience and history of the pricing service• The 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 pricing service’s process for considering price “challenges,” including how the pricing service incorporates information received

from pricing challenges into its pricing information• The pricing service’s potential conflicts of interest and the steps it takes to mitigate such conflicts• The testing processes used by the pricing service

– Rule 2a-5 would also require funds to establish criteria for price challenges


SIDLEY AUSTIN LLP 8


• Fair value policies and procedures– Funds must establish written policies and procedures “reasonably designed to achieve compliance with the requirements of” Rule 2a-5– If the board “assigns” to the adviser the responsibility to determine fair value, then this would be the responsibility of the adviser

• Recordkeeping– Funds must maintain

• Documentation to support fair value determinations (specific methodologies and assumptions) for at least five years from the time the determination was made, the first two in an easily acceptable place

• A copy of required policies and procedures in effect for the past five years


SIDLEY AUSTIN LLP 9


• Rule 2a-5 would allow boards to “assign” to the adviser five core valuation functions, subject to “robust board oversight”– Boards could continue to retain this responsibility if they choose– The ability to assign these responsibilities reflects SEC’s belief that compliance with the 1940 Act does not require directors to perform

each specific task to fair value securities– Assignable responsibilities include:

• Fair value determinations• Establish and apply fair value methodologies• Test fair value methodologies• Evaluate of pricing services• Adopt and implement fair value policies and policies

– Boards could assign responsibilities to various sub-advisers


SIDLEY AUSTIN LLP 10

Assignment of fair valuation determinations

• Board oversight– SEC adopted a principles-based approach to board oversight– Boards should approach oversight of fair value determinations with a “skeptical and objective view”

• Oversight cannot be a “passive activity”– Boards should seek to “identify potential issues and opportunities to improve the fund’s fair value processes”– The SEC said that among other things, directors should:

• Ask questions and seek relevant information• Request follow up information when appropriate• Use the appropriate level of scrutiny based on the fund’s valuation risk• Seek to identify potential conflicts of interest, monitor such conflicts and take reasonable steps to manage such conflicts in order

to serve as a meaningful check on the conflicts of interest of the adviser and other service providers involved in the determination of fair value

• 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, with respect to valuation




• Board reporting– When a board “assigns” the fair value functions to and adviser, the adviser, at least quarterly, must provide reports with information

reasonably necessary for the board to evaluate the valuations• Reports “are intended to supplement, not replace” director oversight

– At a minimum, quarterly reports must cover:• Assessment and management of material valuation risk, including any material conflicts of interest• Any material changes to, or material deviations from, methodologies• The results of any testing of fair value methodologies• The adequacy of resources allocated to the process for determining the fair value of the fund’s assigned investments, including any

material changes to the roles or functions of the persons responsible for determining the fair value • Any material changes to the adviser’s process for overseeing pricing services, including any material events such as changes of

service providers used or price overrides– Advisers must also promptly report on matters that could materially affect fair value determinations




• Specification of functions– When a board assigns fair valuation responsibilities to an adviser, the adviser must specify:

• the titles of the persons responsible for determining the fair value of the assigned investments• The particular functions for which each person is responsible

– Advisers must “reasonably segregate” the process of making fair value determinations from the portfolio management of the fund• Requirement is designed to avoid conflicts of interest when portfolio managers have an incentive to direct valuations

• Records of assignment– Funds would be required to keep:

• Copies of required reports and other information provided to the board• A specified list of the investments or types of investments whose fair value determinations have been assigned to the adviser




• Section 2(a)(41) of the 1940 Act – If a market quotation is readily available for a portfolio holding, it must be valued at market value– If a market quotation is not readily available, the value is fair value as determined in good faith by the board

• What is “readily available?”– A market quotation is readily available only when that quotation is a quoted price (unadjusted) in active markets for identical

investments that the fund can access at the measurement date• A quotation is not considered readily available if it is not reliable• A quotation is not considered reliable when it would require adjustment under GAAP or when GAAP would require consideration of

additional inputs.



Readily available market quotations

• The SEC proposes to rescind certain prior guidance for funds concerning valuation– Recognition that FASB accounting standards have modernized the approach to accounting topics addressed in old accounting

releases (ASR 113 and ASR 118)• The SEC also would rescind or withdraw certain staff letters that would be moot or superseded by Rule 2a-5



Rescission of prior SEC guidance

• The SEC would provide a transition period of one year after publication of the final rule in the Federal Register• Comments are due July 21, 2020



Transition and comment periods

• As with all principles-based rules, this rule would allow funds and fund directors to design policies and procedures that reflect the facts and circumstances of particular funds and boards

• Rather than sift through decades of SEC releases and no action letters, advisers, directors and their counsel would look to uniform guidance in one centralized regulatory place

• Boards that assign fair valuation responsibilities to advisers will be under increased scrutiny to ensure that the policies and procedures are appropriate and effective, and that advisers are carrying out their assigned responsibilities

• Will funds designate a Chief Valuation Officer?



Compliance considerations

19

Implications for Fund Boards

Buddy DonohueIndpendent DirectorBNY Mellon Funds

20

Fund Operations & Service Provider Issues

Ian BlanceManaging DirectorVoltaire Advisors

21

Operations & Service Providers

u In-house Pricing Teams

u Fund Administrators

u Pricing Services

22

Rule 2a-5 Summary

u Material Valuation Risks

u Fair Value Methodologies

u Pricing Services

u Policies & Procedures

u Record Keeping

23

Valuation Risks

u No definitive list of risks / frequency of re-assessment prescribed

u Use of unobservable inputs, especially if provided by adviser

u Reliance on third party service providers with limited expertise in asset class

u Inputs provided by the third party

u Inputs contributed by a provider of the third party (‘fourth party’) and risks therein

24

Fair Value Methodology

u Risk of inconsistent / incorrect application

u Consistency with definition of fair value ASC Topic 820

u Criteria for determining when market prices are not available/reliable – Level 2 and 3?

u Establishment of a methodology in advance of investment

u Specify testing methods and frequency

u Back testing and calibration

u Use of Broker Dealers

25

Pricing Services

u Factors for approval, monitoring and evaluation of pricing services

o Qualifications, experience and history

o Valuation methods, techniques, inputs and assumption

o Price challenge process

o Potential conflicts of interest

o Testing processes

u Criteria for price challenges and overrides

u Evaluated pricing not ‘readily available market quotations’ under the Act

26

Policies & Procedures

u Can replace fair valuation section of rule 38a—1

u Requires board approval

u Quarterly written updates to board on adequacy and effectiveness including:o Material valuation risks

o Material changes to or deviations from methodologies

o Testing results

o Resources devoted to fair value determination

o Use and due diligence of pricing services

o Any other material requested

u Titles and functions of persons responsible for fair valuation and price challenges/overrides

u Reasonable segregation of pricing from fund management – but no ‘firewall’

27

Reporting & Record Keeping

u Supporting documentation on methodologies, inputs and assumptions

u ‘Sufficient for a third party to verify the fair value determination’

u Documentation on back testing, calibration and stale prices

u Policies & Procedures and any changes in these

u Quarterly reporting generally plus reporting of material fair value issues within three days

28

Some Key Points

u Identify and test inputs and assumptions (in-house, broker dealer, third party, ‘fourth party’)

u Ensure consistent and correct application of fair value methods

u Base fair valuation criteria on ASC Topic 820 framework (i.e. Level 2 and 3)

u Regularly test fair value pricing

u Conduct full due diligence of third party pricing services

u Ensure appropriate segregation of valuation duties in adviser

u Provide sufficient documentation to allow verification of fair values

29

Audience Q&A

Thank You!PARTICIPANTS WILL RECEIVE A COPY OF THE SLIDE DECK AND A RECORDING OF THE WEBINAR

TOMORROW.

31

Contact Us

Voltaire Advisors

14 Wall Street No.1 PoultryNew York London

NY 10002 EC2R 8JRUSA UK

+44 800 677 [email protected]

Documents

Proposed SEC Fair Value Rule 2a-5 2a-5 - May 2020...TALENT. TEAMWORK. RESULTS. Proposed SEC Fair Value Rule 2a-5 Implications for Funds, Boards and Service Providers Voltaire Advisors