Fair Value Pitfalls: How to Avoid an SEC Deficiency Letter under Rule 2a-5

This blog piece was written by FinTech Law Managing Director Bo Howell in partnership with Joot team members Charles Black and Jessica Roeper. Rule 2a-5 under the Investment Company Act took effect in September 2023. Since then, the SEC has been including a review of related policies and procedures in both sweep and regular examinations of investment companies subject to the rule and their investment advisers, who are typically designated the “Valuation Designee.” Below are some key findings from these examinations that should be implemented into every fair value process under Rule 2a-5.

Board Reporting

Most funds already provide some level of board reporting as required by Rule 2a-5, but the SEC has found some of this reporting insufficient. Here are some required details that must be included in every quarterly report.

• All fair - valued securities should be included in the report, even if there has been no change since the last report. Providing a sample of fair - valued securities or a general description of certain types of securities that are fair - valued will not meet the requirements .
• The fair value methodology relating to each fair-valued position must be included in the report, even if it was previously reviewed by the board.
• The quarterly report must include a summary of the testing that was conducted during the period by the Valuation Designee, who has an affirmative duty to test all positions periodically, not just when new information is received.

Limit the Influence of Portfolio Managers

Rule 2a-5 allows a portfolio manager to provide input into the fair valuation process, but specifically prohibits the portfolio manager from exerting substantial influence on the fair value determinations. The staff has noted the following scenarios suggest the portfolio manager is exerting substantial influence on the process.

• The portfolio manager is “supported” by only one other employee of the adviser. In other words, a committee of two people, with one being the portfolio manager, may be a case of substantial influence unless the other person is equivalent or higher in seniority to the portfolio manager.
• The portfolio manager has the final say on the fair valuations.
• The portfolio manager is the sole liaison between the Valuation Designee and the board.

Failure to Document Periodic Testing

As required by the rule, the Valuation Designee must conduct fair value testing on a periodic basis . Rule 2a-5 allows for the f und to determine the minimum frequency of testing and the methodology of testing . The testing can include some form of backtesting or similar methods of measuring the accuracy of the fair value determinations over the period. In addition to including the results of such testing in the quarterly board reporting (see above), the Valuation Designee must document the testing that it conducts. Additionally, the testing must be done on all fair valued positions, not just a sample of them.

Fair Value Measurement under ASC Topic 820

The SEC staff has noted that the Financial Accounting Standards Board (“FASB”) has established Accounting Standard Codification 820: Fair Valuation Measurement (“ASC Topic 820”). Under that standard, “[a] fter initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reflect observable market data (for example, the price for a similar asset or liability) at the measurement date.” The staff has further noted that the Rule 2a-5 Adopting Release states, “ an appropriate methodology must be consistent with those used to prepare the fund's financial statements and thus be consistent with the principles of the valuation approaches laid out in ASC Topic 820. Therefore, if a valuation methodology was used that is not consistent with the principles of the valuation approaches laid out in ASC Topic 820, we would presume that the use of such a methodology would be misleading or inaccurate.” Certain valuation techniques, such as valuing securities at cost for a year, can be deemed inconsistent with ASC 820 and U.S. generally accepted accounting principles. Therefore, the use of such techniques would violate Rule 2a-5. Valuation methodologies such as practical expediency , which is commonly used for valuating investments in private funds, are permitted but must be documented by the Valuation Designee and reported to the board.

Adjustments to Fair Valuation Methodologies

Finally, we note that any adjustments to a fair value methodology must be explained, documented, and reported to the board. If a Valuation Designee is using a methodology such as discounted cash flow analysis or other quantitative models, then it needs to document the reasons for any changes to the model or adjustments in inputs. Further, such changes should be reported to the board at its next quarterly meeting and noted in the board minutes, along with supporting documentation in the board materials.

Assistance with Fair Valuation and Rule 2a-5

As your business processes regarding fair valuation or Rule 2a-5 continue, don't hesitate to reach out to the FinTech Law team for any fair valuation or Rule 2a-5 questions.