SEC Final rule 2a-5 – Good faith determinations of fair value

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Overview

On December 3, 2020, the SEC announced adoption of rule 2a-5 (the “Rule”), largely as proposed with a few modifications incorporating certain feedback received from 60+ comment letters. The Rule directly applies to registered investment companies and business development companies, and establishes a consistent, principles-based framework for boards of directors to use in creating their own specific processes in order to determine fair values in good faith. The SEC determined an update to the Investment Company Act (which had last been amended in 1970) was needed to account for new regulatory developments (including the adoption of ASC 820, Fair Value Measurement) and the increasingly complex nature of investments held by public funds. While the ultimate responsibility of compliance with the Rule’s requirements rests with the board of directors, the Rule allows the board to designate the performance of fair value determinations to a “designee”, provided that such designee has a fiduciary duty to the fund such as the fund’s adviser or an officer of an internally managed fund.

Key provisions

The Rule is comprised of two main areas:

1. The specific requirements that must be performed to determine fair values in good faith, which include:

  • Assessing and managing valuation risks;
  • Establishing and applying fair value methodologies;
  • Testing fair value measurements for appropriateness and accuracy; and
  • Monitoring and evaluating pricing services used.

2. The oversight responsibilities of the board should it choose to designate the performance of fair value determinations to a designee, which include:

  • Actively overseeing the valuation designee, which involves scrutinizing the information received, asking probing questions, reviewing the designee’s resources, and identifying and managing conflicts of interest of the designee; and 
  • Receiving reporting from the designee on a quarterly basis for any material changes in valuation risks or valuation methodologies used, and on an annual basis for an assessment of the adequacy and effectiveness of the designee’s valuation process.

As part of the finalization of the Rule, the SEC separated the proposed recordkeeping requirements to new rule 31a-4, confirming that a failure to keep required records would not automatically imply that the board had not determined fair value in good faith. In addition, the SEC amended the required time period to maintain appropriate documentation to support fair value determinations to six years (in an easily accessible place for the first two years). The SEC reiterated that if the board designates fair value determinations, the valuation designee (not the fund) would be required to maintain such records.

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