The Securities and Exchange Commission (SEC) recently provided some expanded valuation guidance to mutual funds in its release on Money Market Fund Reform dated July 23, 2014.  The guidance is applicable to any fund, including but not limited to money market funds, that holds short-term debt securities or debt securities that are thinly traded.

Valuation of Short-Term Debt Securities

One aspect of the guidance concerned amortized cost valuation.  The SEC reminded the fund industry that all registered investment companies and business development companies may continue to use amortized cost to value debt securities with remaining maturities of 60 days or less (Short-Term Debt Securities) only if the fund directors determine in good faith that the fair value of the securities is their amortized cost value.  Many non-money market and most money market funds currently disclose that they use amortized cost to value Short-Term Debt Securities.  A Short-Term Debt Security’s amortized cost value may not equal its fair value, according to the SEC, when the creditworthiness of the issuer of the security is impaired or for other reasons.  The SEC addressed how often comparisons of amortized cost valuations to the fair value of Short-Term Debt Securities should be made and the permissible extent of deviation between the two values.   In that regard, the SEC believes that a fund may use the amortized cost method for Short-Term Debt Securities only when it can reasonably conclude, at each time it makes a valuation determination, that the amortized cost value of the portfolio security is approximately the same as the fair value of the security as determined without the use of amortized cost valuation.  The SEC further stated that in fair valuing a security, funds should take into account factors such as credit, liquidity and interest rate conditions as well as issuer specific factors. 

The SEC’s emphasis on reviewing amortized cost valuations at each valuation appears to raise the bar for funds.  For stable net asset value (NAV) money market funds, the SEC instructed that each fund should have readily available market prices on a daily basis to help management and the board to monitor any potential deviation in amortized cost versus market price because those funds will be required to calculate “shadow prices” each day.  However, it appears that the SEC may expect other funds to compare a security’s amortized cost with its fair value on a daily basis as these funds’ NAVs are calculated daily.  The SEC also expects that funds will have written policies and procedures that address the monitoring of market and issuer-specific developments that may indicate that the amortized cost of a Short-Term Debt Security may no longer be appropriate.

Valuation of Thinly Traded Securities

The SEC also provided guidance on thinly traded securities such as commercial paper, repurchase agreements, certificates of deposit and other similar securities that do not actively trade in the secondary market.  The SEC observed that these types of securities are typically fair valued in good faith by the board.  The SEC stressed that the fair value of a security is the amount that a fund might reasonably expect to receive for the security upon its current sale.  As a result, funds should not value these securities at par or amortized cost based on the expectation that the securities will be held to maturity if the funds could not reasonably expect to receive approximately that value upon the current sale of the securities under current market conditions.

Lastly, the SEC noted that many funds, including money market funds, use “evaluated” prices provided by pricing services to value portfolio securities.  “Evaluated” prices are generally based on a pricing service’s model.  The SEC emphasized that a fund’s board of directors “has a non-delegable responsibility to determine whether an evaluated price provided by a pricing service, or some other price, constitutes fair value for a fund’s portfolio security.”  The SEC does not expect that boards will be making the actual calculations of fair value – that function is something that the SEC believes can be handled by the fund’s investment adviser or a valuation committee.  But the release states that a board must become involved in understanding the pricing service’s inputs, methods, models and assumptions for its evaluated prices and how they are affected by changing market conditions.  The SEC said in the release that, in choosing a particular pricing service, a board may want to assess the quality of the evaluated prices provided and the extent to which the pricing service determines its price as close as possible to the time that the fund calculates its net asset value.  Furthermore, the SEC explained that the board should have a “good faith basis” for believing that a pricing service’s pricing methodologies produce evaluated prices that reflect what the fund could reasonably expect to receive for its securities in a sale under current market conditions.

Practice Tips for Boards and Compliance Officers

Boards may want to consider discussing with management whether and to what extent the funds that they oversee use amortized cost for valuing Short-Term Debt Securities and whether current fund and service provider valuation policies and procedures comply with the SEC’s expanded guidance.  Boards may also want to consider discussing with management a fund’s use of evaluated prices and approving the pricing services to be used, based upon management’s recommendations.  In cases where a fund is relying on evaluated prices, the board may want to consider meeting as appropriate with, and/or requesting detailed information from, pricing services that provide these prices so that the board can consider the appropriateness of continuing to use evaluated prices provided by the pricing service.

Compliance officers may also want to consider reviewing fund and service provider valuation policies and procedures for compliance with the SEC’s expanded valuation guidance.

If you have any questions concerning this alert, please contact your regular Drinker Biddle lawyer or any member of our Investment Management Group.

Source: Investment Management Alert