United States: Fair Valuation And Mutual Fund Directors: New Guidance From The SEC*

In June, I began a series of Client Alerts on Fair Valuation and Mutual Fund Directors. The third installment in the series was released in July. Although I was not certain what path the series would take, I knew where it would end—with an irrefutable argument that it was past time for the SEC to address the use of pricing services to fair value securities, particularly fixed-income securities.

In policy arguments, as in comedy, timing is everything. The SEC stole my punch line when it recently issued new guidance on the use of pricing services. The guidance is buried in the bowels (an apt phrase in this instance) of the SEC's July 23 release adopting money market fund reforms (the "Release"). A section providing "Guidance on the Amortized Cost Method of Valuation and Other Valuation Concerns" begins at page 270 of the 869-page release.¹ The SEC tacked much of the 11 pages of guidance onto section 404.05 of the Codification of Financial Reporting Policies (the "CFRP").

Given the context, directors may be forgiven for hoping that this guidance is limited to money market funds. The Release states, however, that (unless otherwise noted) "this guidance is applicable to all registered investment companies and business development companies."²

This Client Alert provides a summary of the guidance "applicable to all registered investment companies." The first section summarizes guidance previously provided by the SEC and its staff that has been added to the CFRP. The second section summarizes new guidance regarding use of evaluated prices from pricing services; the third section summarizes new guidance on the use of amortized cost. A proper assessment of the guidance will need to wait for later Client Alerts, after we have had more time to reflect on these reforms.

1. Previous Guidance Codified by the Release

Much of the guidance included in the Release is already in section 404 of the CFRP. In fact, the amount of repetition in the revised section may confuse a first-time reader. For example, subsection 404.03.b.iv (Securities Valued "in Good Faith") already stated, "it is incumbent upon the board of directors to satisfy themselves that all appropriate factors relevant to the value of securities for which market quotations are not readily available have been considered and to determine the method of arriving at the fair value of each such security." New subsection 404.05.c.2 (Other Valuation Matters) quotes this statement verbatim, both in footnote 896 and in the sentence immediately following this footnote. Like Lewis Carroll's Bellman, when it comes to valuation guidance, "What [the SEC] tell[s] you three times is true."³

New subsection 404.05.c also contains some existing guidance not previously included in the CFRP, particularly:

• "Directors cannot delegate their statutory duty to determine the fair value of fund portfolio securities,"⁴ although the SEC reaffirmed that directors "may appoint persons to assist them in the determination of such value, and to make the actual calculations pursuant to the board's direction."⁵
• Money market funds may not use amortized cost for purposes of "shadow pricing" their portfolios, that is, monitoring deviations of the fund's net asset value "calculated using available market quotations (or an appropriate substitute that reflects current market conditions)" from its amortized cost value.⁶
• "Fair value cannot be based on what a buyer might pay at some later time, such as when the market ultimately recognizes the security's true value as currently perceived by the portfolio manager. Funds also may not fair value portfolio securities at prices not achievable on a current basis on the belief that the fund would not currently need to sell those securities."⁷

This last statement comes from the Heartland Directors Order discussed in the first Client Alert.⁸ This may be a useful reminder for attorneys to take care when negotiating offers of settlement, as they may be creating new standards for all funds and their directors.

2. Guidance Regarding the Use of Pricing Services

This new subsection of the CFRP begins by noting, "evaluated prices provided by pricing services are not, by themselves, 'readily available' market quotations or fair values 'as determined in good faith by the board of directors' ...."⁹ It is important to understand that not all prices obtained from a pricing service are "evaluated prices." As the third Client Alert explained, many pricing services compile and disseminate official closing prices and published bid/asked prices for exchange-traded securities. These prices qualify as market quotations, regardless of their source, and are not subject to the SEC's new guidance.

The third Client Alert also showed why market quotations are generally not available for most fixed-income securities or other securities traded over the counter. For these securities, pricing services provide "evaluated prices": prices based on the pricing service's proprietary pricing models and, typically, observable market inputs. With regard to evaluated prices, pricing services "acknowledge that they provide only 'good faith' opinions on valuation."¹⁰ As mere opinions, evaluated prices cannot qualify as "market quotations," and as opinions of someone other than the fund's board of directors, evaluated prices cannot qualify as "fair values." As the second Client Alert explained, this precludes funds from treating an evaluated price as the "value" of a portfolio security for purposes of the Investment Company Act of 1940.

Pricing services therefore must fall within the category of persons whom directors "may appoint ... to assist them in the determination of such value, and to make the actual calculations pursuant to the board's direction." In selecting a pricing service to provide such assistance, new subsection 404.5.c suggests that directors may want to consider:

• "the inputs, methods, models, and assumptions used by the pricing service to determine its evaluated prices;"
• how changes in market conditions may affect these factors;
• "the quality of the evaluated prices provided;" and
• "the extent to which the service determines its evaluated prices as close as possible to the time as of which the fund calculates its net asset value."¹¹

Finally, directors have an ongoing duty continuously to review the appropriateness of the method used in fair valuing a portfolio security. Directors should not rely on evaluated prices if they do "not have a good faith basis for believing that the pricing service's pricing methodologies produce evaluated prices that reflect what the fund could reasonably expect to obtain for the securities in a current sale under current market conditions."¹²

This guidance is new – not in the sense that the SEC has never made statements to this effect before – but insofar as the SEC has never directed such statements to the use of pricing services generally. For example, the Heartland Directors Order recited that evaluated prices were to be used "as benchmarks to fair value the Funds' securities,"¹³ which implies that evaluated prices are not, "by themselves," market quotations or fair values determined in good faith by the board of directors. The order was quoting the board's valuation procedures, however, rather than purporting to express the view of the SEC. In addition, the enforcement actions, to the extent they involved pricing services, found violations by independent directors with respect to fair values used to override pricing services, and thus did not address the use of the services' evaluated prices "by themselves."

3. Guidance Regarding Use of Amortized Cost

This new subsection of the CFRP begins by discussing money market funds in particular, but then refers to the possibility that "managers of floating NAV money market funds may have an incentive to use amortized cost valuation whenever possible in order to help stabilize the funds' NAV per share."¹⁴ Apparently, the SEC intends for the new guidance in this subsection to apply to all mutual funds that use amortized cost as a fair value.

The inclusion of non-money market funds is important, because the guidance is intended to clarify "how frequently funds should compare a debt security's amortized cost value to its fair value determined using market-based factors and what extent of deviation between the two values is permissible."¹⁵ As noted above, "shadow pricing" refers to this process of calculating the deviation of amortized cost from a market-based estimate of a security's fair value. According to the new guidance, so long as the shadow price of a security "is approximately the same as" [the SEC's emphasis] its amortized cost, an investment company may use the amortized cost as the fair value of a security with a remaining maturity of 60 days or fewer.¹⁶

This implies that any investment company using amortized cost as the fair value of any securities must shadow price these securities. Moreover, the investment company must shadow price "each time it makes a valuation determination"¹⁷ [SEC's emphasis]. According to the SEC, comparing shadow prices with amortized cost only after, for example, "there is a significant change in interest rates or credit deterioration," or "only quarterly or each time the fund produces financial statements," would not be sufficient.

4. Implication for Independent Directors

As noted in the introduction, an in-depth discussion of this new guidance must await further Client Alerts. Nevertheless, it is possible to make a few superficial observations. First, directors should review their existing policies and procedures for determining the fair value of securities. Directors should consider whether revisions to these policies and procedures might be necessary to:

Avoid any implication that the board of directors has delegated its responsibility to fair value securities to a pricing service, a valuation committee or any other person.

Explicitly treat evaluated prices from pricing services at inputs into fair values, rather than as fair values "by themselves."

Conform the process for selecting and monitoring pricing services to the new guidance.

Identify any difference between the time as of which a pricing service determines its evaluated prices and the time as of which a fund calculates its NAV.

Require the daily shadow pricing of all securities with remaining maturities of 60 days or fewer valued at amortized cost.

Regarding this last point, insofar as non-money market funds typically hold small amounts of securities with remaining maturities of 60 days or fewer, directors may want to consider simply using the shadow price of these securities, rather than amortized cost, as their fair value.

Second, directors should request a review of current disclosures regarding their funds' fair valuation process. Such disclosures should not imply that the board of directors has delegated its responsibility to fair value securities or that evaluated prices are market quotations.¹⁸

Finally, if they have not done so already, directors should study the "inputs, methods, models, and assumptions used by" their funds' pricing services. This is a necessary step for assessing the feasibility of independent directors complying with the SEC's new guidance on fair valuation.

Footnotes

* David R. McCandless assisted in the research for this Client Alerts.

1. Money Market Fund Reform; Amendments to Form PF, Inv. Co. Act Rel. 31166, 79 Fed. Reg. 47736 (adopted July 23, 2014; pub. Aug. 14, 2014).

2. Id. at 47812, n. 873.

3. Lewis Carroll, The Hunting of the Snark.

4. CFRP (CCH) section 404.05.c.2.

5. CFRP (CCH) section 404.03.b.iv.

6. CFRP (CCH) section 404.c.1, n. 873.

7. CFRP (CCH) section 404.c.2, n. 891.

8. In the Matter of Jon D. Hammes, et al., Inv. Co. Act Release No. 26290, 81 S.E.C. Docket 2467 (Dec. 11, 2003).

9. CFRP (CCH) section 404.05.c.2.

10. Release at 47814.

11. CFRP (CCH) section 404.05.c.2.

12. Id.

13. Heartland Directors Order, supra note 9, at section C, paragraph 1.

14. CFRP (CCH) section 404.05.c.1.

15. Id.

16. Id.

17. Id.

18. We published a due diligence checklist for this purpose in Drafting NAV Disclosure: Some Practical Considerations, CITI INVESTMENT MANAGEMENT REVIEW, No. 7, 19 (June 2008).

This article is presented for informational purposes only and is not intended to constitute legal advice.