[Federal Register Volume 85, Number 93 (Wednesday, May 13, 2020)]
[Proposed Rules]
[Pages 28734-28770]
[FR Doc No: 2020-08854]

Vol. 85

Wednesday,

No. 93

May 13, 2020

Part III

Securities and Exchange Commission

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17 CFR Parts 210 and 270

 Good Faith Determinations of Fair Value; Proposed Rule

Federal Register / Vol. 85 , No. 93 / Wednesday, May 13, 2020 /
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 270

[Release No. IC-33845; File No. S7-07-20]
RIN 3235-AM71

Good Faith Determinations of Fair Value

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing a new rule (``rule 2a-5'') under the Investment Company Act
of 1940 (the ``Investment Company Act'' or the ``Act'') that would
address valuation practices and the role of the board of directors with
respect to the fair value of the investments of a registered investment
company or business development company (a ``fund''). The proposed rule
would provide requirements for determining fair value in good faith
with respect to a fund for purposes of section 2(a)(41) of the Act.
This determination would involve assessing and managing material risks
associated with fair value determinations; selecting, applying, and
testing fair value methodologies; overseeing and evaluating any pricing
services used; adopting and implementing policies and procedures; and
maintaining certain records. The proposed rule would permit a fund's
board of directors to assign the fair value determination to an
investment adviser of the fund, who would then carry out these
functions for some or all of the fund's investments. This assignment
would be subject to board oversight and certain reporting,
recordkeeping, and other requirements designed to facilitate the
board's ability effectively to oversee the adviser's fair value
determinations. The proposed rule would include a specific provision
related to the determination of the fair value of investments held by
unit investment trusts, which do not have boards of directors. The
proposed rule would also define when market quotations are readily
available under section 2(a)(41) of the Act. If rule 2a-5 is adopted,
the Commission would rescind previously issued guidance on the role of
the board of directors in determining fair value and the accounting and
auditing of fund investments.

DATES: Comments should be submitted on or before July 21, 2020.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/interp.shtml); or
     Send an email to<EMAIL_ADDRESS>Please include
File Number S7-07-20 on the subject line.

Paper Comments

     Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-07-20. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
internet website (http://www.sec.gov/rules/interp.shtml). Comments are
also available for website viewing and printing in the Commission's
Public Reference Room, 100 F Street NE, Washington, DC 20549, on
official business days between the hours of 10:00 a.m. and 3:00 p.m.
All comments received will be posted without change. Persons submitting
comments are cautioned that we do not redact or edit personal
identifying information from comment submissions. You should submit
only information that you wish to make publicly available.
    Studies, memoranda or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Joel Cavanaugh, Senior Counsel;
Bradley Gude, Senior Counsel; Thoreau A. Bartmann, Senior Special
Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-
6792, Investment Company Regulation Office, Division of Investment
Management; Kieran G. Brown, Senior Counsel, or David J. Marcinkus,
Branch Chief, at<PHONE_NUMBER> or<EMAIL_ADDRESS>Chief Counsel's
Office, Division of Investment Management; Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-8549. Regarding
accounting and auditing matters: Jenson Wayne or Alexis Cunningham,
Assistant Chief Accountants, or Jacob Sandoval, Branch Chief, at (202)
551-6918 or<EMAIL_ADDRESS>Chief Accountant's Office, Division of
Investment Management, Securities and Exchange Commission; or Jamie
Davis or Thomas Collens, Professional Accounting Fellows, at (202) 551-
5300 or<EMAIL_ADDRESS>Office of the Chief Accountant, Securities and
Exchange Commission.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment 17 CFR 270.2a-5 (new rule 2a-5) under the Investment Company
Act.

Table of Contents

I. Introduction
II. Discussion
    A. Fair Value as Determined in Good Faith Under Section 2(a)(41)
of the Act
    1. Valuation Risks
    2. Fair Value Methodologies
    3. Testing of Fair Value Methodologies
    4. Pricing Services
    5. Fair Value Policies and Procedures
    6. Recordkeeping
    B. Performance of Fair Value Determinations
    1. Board Oversight
    2. Board Reporting
    3. Specification of Functions
    4. Records of Assignment
    C. Readily Available Market Quotations
    D. Rescission of Prior Commission Releases
    E. Existing Staff No-Action Letters, Other Staff Guidance, and
Proposed Transition Period
III. Economic Analysis
    A. Introduction
    B. Economic Baseline
    1. Current regulatory framework
    2. Current practices
    3. Affected parties
    C. Benefits and Costs and Effects on Efficiency, Competition,
and Capital Formation of Proposed Rule
    1. General Economic Considerations
    2. Benefits
    3. Costs
    4. Effects on Efficiency, Competition, and Capital Formation
    D. Reasonable Alternatives
    1. More Principles-Based Approach
    2. Assignment of Responsibilities to Service Providers Other
Than Investment Advisers
    3. Not Permit Boards To Assign Fair Value Determinations to an
Investment Adviser
    E. Request for Comment
IV. Paperwork Reduction Act Analysis
    A. Introduction
    B. Policies and Procedures
    C. Board Reporting
    D. Recordkeeping
    E. Proposed Rule 2a-5 Total Estimated Burden
    F. Request for Comment
V. Initial Regulatory Flexibility Analysis
    A. Reasons for and Objectives of the Proposed Actions
    B. Legal Basis
    C. Small Entities Subject to Proposed Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements

    1. Policies and Procedures
    2. Recordkeeping
    3. Board Reporting
    E. Duplicative, Overlapping, or Conflicting Federal Rules
    F. Significant Alternatives
    G. Request for Comment
VI. Consideration of Impact on the Economy
VII. Statutory Authority

I. Introduction

    The Investment Company Act requires funds to value their portfolio
investments using the market value of their portfolio securities when
market quotations for those securities are ``readily available,'' and,
when a market quotation for a portfolio security is not readily
available, by using the fair value of that security, as determined in
good faith by the fund's board.\1\ The aggregate value of a fund's
investments is the primary determinant of the fund's net asset value
(``NAV''), which for many funds determines the price at which their
shares are offered and redeemed (or repurchased).\2\ Accordingly,
proper valuation, among other things, promotes the purchase and sale of
fund shares at fair prices, and helps to avoid dilution of shareholder
interests.\3\ Valuation also affects the accuracy of funds' asset-based
and performance-based fee calculations; \4\ disclosures of fund fees,
performance, NAV, and portfolio holdings; \5\ and compliance with
investment policies and limitations.\6\ As a result, improper valuation
can cause investors to pay fees that are too high or to base their
investment decisions on inaccurate information.\7\
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    \1\ Section 2(a)(41) of the Investment Company Act. See also
Investment Company Act rule 2a-4.
    \2\ The Investment Company Act requires registered investment
companies that issue redeemable securities to sell and redeem their
shares at prices based on the current net asset value of those
shares. See section 22(c) of the Investment Company Act and rule
22c-1(a) thereunder. Rule 2a-4 defines the term ``current net asset
value'' of a redeemable security issued by a registered investment
company and provides, similar to section 2(a)(41)(B), that
``[p]ortfolio securities with respect to which market quotations are
readily available shall be valued at current market value, and other
securities and assets shall be valued at fair value as determined in
good faith by the board of directors of the registered company.''
Rule 22c-1(a) requires open-end funds to sell, redeem, or purchase
shares at a price based on their current NAV next computed following
receipt of an order.
     Although closed-end funds are not subject to rules 2a-4 and
22c-1 under the Investment Company Act, section 23(b) limits the
ability of closed-end funds to sell their common stock at a price
below current NAV. Section 23(c) of the Investment Company Act
provides for the repurchases of closed-end fund shares. The shares
of closed-end funds (including business development companies
(``BDCs'')) that are listed on an exchange often trade at a premium
or discount to NAV. See Item 1.1(i) of Form N-2 (requiring closed-
end funds whose securities have no history of public trading to
include ``a statement describing the tendency of closed-end fund
shares to trade frequently at a discount from net asset value'').
    \3\ See Investment Company Liquidity Risk Management Programs,
Investment Company Act Release No. 32315 (Oct. 13, 2016)
(``Liquidity Risk Management Release'') (adopting rule 22e-4 under
the Investment Company Act and noting ``the risk of shareholder
dilution associated with improper fund pricing'').
     If fund shares are overpriced, selling shareholders will
receive too much for their shares, and purchasing shareholders will
pay too much for their shares. On the other hand, if fund shares are
underpriced, selling shareholders will receive too little for their
shares, and purchasing shareholders will pay too little for their
shares. See generally Investment Trusts and Investment Companies:
Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking
and Currency, 76th Cong., 3d Sess. 136-38 (1940) (discussing the
effect of dilution on fund shareholders).
    \4\ See section 205 of the Investment Advisers Act of 1940
(``Advisers Act'') (permitting a fund's adviser to receive
compensation based upon the total value of the fund and permitting
certain specified types of performance fee arrangements with funds).
    \5\ See, e.g., Item 3 of Form N-1A (requiring annual fund
operating expenses to be disclosed in the fund's prospectus as a
percentage of the value of a shareholder's investment); Item 4(b)(2)
of Form N-1A (requiring certain disclosures about fund performance
in fund prospectuses); Item 4.1 and Instruction 4.b. to Item 24 of
Form N-2 (requiring disclosure of the fund's NAV in its prospectus
and annual report); Item 6 of Form N-CSR and Sec.  210.12-12 of
Regulation S-X (requiring a schedule of the fund's investments,
including the value of the investment, in the fund's annual report).
    \6\ See Rule 22e-4(b)(1)(iv) (generally prohibiting an open-end
fund from acquiring an illiquid investment if such investment would
cause more than 15% of such fund's net assets to be invested in
illiquid investments). See also Liquidity Risk Management Release,
supra footnote 3; Instruction 4 to Item 9(b)(1) of Form N-1A
(requiring a fund to disclose any policy to invest more than 25% of
its net assets in a particular industry or group of industries).
    \7\ Fund advisers may have an incentive to overvalue fund
assets, for example, to increase fees, but also in some cases may
have incentives to undervalue fund assets, for example to smooth
reported returns or comply with investment policies and
restrictions. See In re Piper Capital Management, et al., Investment
Company Act Release No. 26167 (Aug. 26, 2003) (Commission opinion)
(``Piper'') (``the record shows that Respondents determined to
smooth or ratchet down gradually the Fund's NAV over a period of
days. It appears that Respondents sought to prevent an abrupt drop
in the Fund's NAV as a result of updating the stale prices.''). See
also Gjergi Cici, et al., Missing the Marks? Dispersion in Corporate
Bond Valuations Across Mutual Funds, 101 J. Fin. Econ. 206 (2011)
(observing evidence of price smoothing behavior in mutual funds and
expressing concern that such smoothing may result in sub-optimal
investment decisions) (``Cici et al. 2011'').
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    For these reasons, a number of the substantive requirements of the
Investment Company Act relate to investment company valuation.\8\
Moreover, the federal securities laws impose liability on funds, fund
boards, and advisers for improperly valuing fund investments and for
making material misstatements regarding a fund's valuation
procedures.\9\ Properly valuing a fund's investments also is a critical
component of the accounting and financial reporting for investment
companies.\10\ Section 2(a)(41)(B) defines ``value'' for purposes of
many of the requirements of the Investment Company Act as: (i) With
respect to securities for which market quotations are readily
available, the market value of such securities; and (ii) with respect
to other securities and assets, fair value as determined in good faith
by the board of directors.\11\
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    \8\ See infra footnote 11.
    \9\ See, e.g., 15 U.S.C. 77l(a)(2); 15 U.S.C. 77k; 15 U.S.C.
78j(b); 15 U.S.C. 80a-33(b); 17 CFR 240.10b-5; 17 CFR 270.22c-1(a);
17 CFR 210.4-01(a)(1); 17 CFR 275.206(4)-8.
     Section 206(1) of the Advisers Act makes it unlawful for an
investment adviser to employ any device, scheme or artifice to
defraud any client or prospective client. Section 206(2) of the
Advisers Act makes it unlawful for an investment adviser to engage
in any transaction, practice or course of business that operates as
a fraud or deceit upon any client or prospective client. The
Commission has brought enforcement actions under sections 206(1)
and/or 206(2) of the Advisers Act against advisers for material
misstatements or omissions to a fund's board (such as the failure to
disclose that the adviser is not complying with the fund's stated
valuation procedures) or willfully or recklessly aiding and abetting
the misvaluing of fund investments. See, e.g., In re Morgan Asset
Management, et al., Investment Company Act Release No. 29704 (June
22, 2011) (settlement) (``In re Morgan Asset Management'').
    \10\ Rule 6-02(b) of Regulation S-X defines the term ``value''
to have the same meaning as in section 2(a)(41)(B) of the Investment
Company Act.
    \11\ Section 2(a)(41) of the Investment Company Act defines
``value'' with respect to the assets of registered investment
companies. Section 59 of the Investment Company Act makes section
2(a)(41) applicable to BDCs. Section 2(a)(41)(A) provides the
definition of ``value'' under the Investment Company Act for
purposes of whether an issuer is an investment company under section
3, is a ``diversified company'' or a ``non-diversified company''
under section 5, or exceeds certain investment limitations under
section 12. Section 28(b) of the Investment Company Act contains
provisions for the valuation of the investments of face-amount
certificate companies. Section 2(a)(41)(B) defines value for all
other purposes under the Investment Company Act. Section
2(a)(41)(A)(iii) provides that investments acquired after the last
preceding quarter shall be valued at the cost thereof. In certain
circumstances, section 2(a)(41) permits directors to determine in
good faith the value of securities issued by controlled companies
even though market quotations are available for such securities.
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    The Commission last comprehensively addressed valuation under the
Investment Company Act in a pair of releases issued in 1969 and 1970,
Accounting Series Release 113 (``ASR 113'') and Accounting Series
Release 118 (``ASR 118'').\12\ ASR 113

addressed a number of federal securities law and accounting topics
related to the purchase of restricted securities by funds, including
how to determine fair value \13\ for such securities. A year later, ASR
118 expressed the Commission's views on certain valuation matters,
including accounting and auditing, as well as the role of the board in
the determination of fair value.
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    \12\ Statement Regarding ``Restricted Securities,'' Accounting
Series Release No. 113 (Oct. 21, 1969); Accounting for Investment
Securities by Registered Investment Companies, Accounting Series
Release No. 118 (Dec. 23, 1970). In 1982, the Commission codified
ASR 113 and ASR 118 in the ``Codification of Financial Reporting
Policies'' as section 404.04: `` `Restricted' Securities'' and
section 404.03: ``Accounting, Valuation and Disclosure of Investment
Securities,'' respectively. See Codification of Financial Reporting
Policies, Investment Company Act Release No. 12376 (Apr. 15, 1982)
(codifying certain existing Accounting Series Releases, including
ASR 113 and ASR 118). ASR 113 and ASR 118 continue to be included in
the list of interpretive releases relating to the Investment Company
Act found in 17 CFR part 271 as Investment Company Act Release Nos.
5847 and 6295, respectively. We refer to the releases herein as ASR
113 and ASR 118.
    \13\ We generally use the term ``fair value'' in this release as
that term is used in the definition of ``value'' in the Investment
Company Act, that is, the value of securities for which no readily
available market quotations exist. See section 2(a)(41) of the
Investment Company Act and supra footnote 11.
     In contrast to the Investment Company Act, FASB Accounting
Standard Codification Topic 820: Fair Value Measurement (``ASC Topic
820'') uses the term ``fair value'' to refer generally to the value
of an asset or liability, regardless of whether that value is based
on readily available market quotations or on other inputs.
Accordingly, when we use the term fair value in the release we are
using it to mean fair value as defined under the Investment Company
Act, unless we specifically note that we mean fair value under ASC
Topic 820, such as in the sections below that discuss proposed
rescission of the accounting guidance. See also infra notes 30 and
141.
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    The Commission acknowledged in ASR 113 and ASR 118 that the board
need not itself perform each of the specific tasks required to
calculate fair value in order to satisfy its obligations under section
2(a)(41). However, under ASR 113 and ASR 118 the board chooses the
methods used to arrive at fair value, and continuously reviews the
appropriateness of such methods.\14\ In addition, the Commission stated
that boards should consider all appropriate factors relevant to the
fair value of securities for which market quotations are not readily
available.\15\ Finally, the Commission stated that whenever technical
assistance is requested from individuals who are not directors, the
findings of such individuals must be carefully reviewed by the
directors in order to satisfy themselves that the resulting valuations
are fair.\16\
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    \14\ ASR 118 at 19988 (``it is incumbent upon the Board of
Directors . . . to determine the method of arriving at the fair
value of each such security''). See also Money Market Fund Reform;
Amendments to Form PF, Investment Company Act Release No. 31166
(July 23, 2014) (``2014 Money Market Fund Release'') at n.896
(citing ASR 118). In ASR 113, the Commission similarly stated:
     ``It is the responsibility of the board of directors to
determine the fair value of each issue of restricted securities in
good faith . . . . While the board may, consistent with this
responsibility, determine the method of valuing each issue of
restricted securities in the company's portfolio, it must
continuously review the appropriateness of any method so
determined.''
    \15\ ASR 118 at 19988 (``it is incumbent upon the Board of
Directors to satisfy themselves that all appropriate factors
relevant to the fair value of securities for which market quotations
are not readily available have been considered''). See also 2014
Money Market Fund Release, supra footnote 14, at n.896 (citing ASR
118).
    \16\ ASR 118.
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    Since ASR 113 and ASR 118 were issued, markets and fund investment
practices have evolved considerably. Funds now invest in a greater
variety of securities and other instruments, some of which did not
exist in 1970 and may present different and more significant valuation
challenges.\17\ Furthermore, advances in communications and technology
have greatly enhanced the availability and currency of pricing
information.\18\ Today there is a greater volume of data available that
may bear on determinations of fair value, and new technologies have
developed that facilitate enhanced price discovery and greater
transparency.\19\ Many funds also now engage third-party pricing
services to provide pricing information, particularly for thinly traded
or more complex assets.\20\
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    \17\ See Use of Derivatives by Registered Investment Companies
and Business Development Companies; Required Due Diligence by
Broker-Dealers and Registered Investment Advisers Regarding Retail
Customers' Transactions in Certain Leveraged/Inverse Investment
Vehicles, Investment Company Act Release No. 33704 (``Derivatives
Release'') (Nov. 25, 2019) (noting the dramatic growth in the volume
and complexity of the derivatives markets over the past two decades,
and the increased use of derivatives by certain funds); Use of
Derivatives by Investment Companies under the Investment Company Act
of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) at
69 (noting that ``[v]aluation of some derivatives may present
special challenges for funds'').
     The fund industry has grown tremendously in the intervening
years. For example, in December 1969, open-end funds had net assets
of over $53 billion. See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 2
(1970). As of August 31, 2019, there were 12,040 open-end funds
registered with the Commission with total net assets of nearly $28
trillion. (We estimate the number of registered investment companies
and their net assets by reviewing all Forms N-CEN filed with the
Commission between June 2018 and August 2019.) Moreover, as of June
2019, there were 99 BDCs with $63 billion in total net assets.
(Estimates of the number of BDCs and their net assets are based on a
staff analysis of Form 10-K and Form 10-Q filings as of June 30,
2019.) BDCs, which did not exist in 1970, must invest at least 70%
of their assets in certain investments that may be difficult to
value. See Section 55(a) of the Act.
    \18\ For example, FINRA's TRACE introduced in 2002 is an over-
the-counter real-time price dissemination service for the fixed
income market. See https://www.finra.org/sites/default/files/TRACE_Overview.pdf
    \19\ For example, the Electronic Municipal Market Access
(``EMMA'') website, available since 2009, ``provides free public
access to objective municipal market information and interactive
tools for investors, municipal entities and others.'' See https://emma.msrb.org/#.
    \20\ 2014 Money Market Fund Release, supra footnote 14 (``many
funds . . . use evaluated prices provided by third-party pricing
services to assist them in determining the fair values of their
portfolio securities'').
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    In addition, three significant regulatory developments since 1970
have fundamentally altered how boards, advisers, independent auditors
(also referred to herein as ``independent accountants''), and other
market participants address valuation for various purposes under the
federal securities laws.
    The first such development was the enactment of the Sarbanes-Oxley
Act of 2002 (the ``Sarbanes-Oxley Act'') and the adoption of rules
mandated by the Sarbanes-Oxley Act.\21\ In particular, the Sarbanes-
Oxley Act established the Public Company Accounting Oversight Board
(``PCAOB''). The PCAOB oversees the audits of companies that are
subject to the federal securities laws, and related matters, in order
to protect the interests of investors and further the public interest
in the preparation of informative, accurate, and independent audit
reports.\22\ The PCAOB also has the authority to establish or adopt,
among other things, professional standards, including audit and quality
controls standards, to be used by registered public accounting firms in
the preparation and issuance of audit reports.\23\ In addition, section
108 of the Sarbanes-Oxley Act established criteria necessary for the
work product of an accounting standard-setting body to be recognized as
``generally accepted'' for purposes of the federal securities laws.\24\

Rule 30a-3 under the Investment Company Act, which was adopted in part
to implement certain requirements of the Sarbanes-Oxley Act, requires
registered management investment companies to maintain disclosure
controls and procedures and internal control over financial
reporting.\25\
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    \21\ Sarbanes-Oxley Act, Public Law 107-204, 116 Stat. 745.
    \22\ See Sarbanes-Oxley Act, supra footnote 21, at Title I Sec.
101(a).
     PCAOB auditing standards apply to the preparation or issuance
of ``audit reports,'' which are defined to include documents,
reports, notices, or other records that, among other things, are
prepared following an audit performed for purposes of compliance by
an issuer, broker, or dealer with the requirements of the securities
laws. See PCAOB rule 3200; PCAOB rule 1001(a)(vi). See also PCAOB
rule 1001(i)(iii) (defining the term ``issuer'' to include issuers
(as defined in Section 3 of the Securities Exchange Act of 1934 (the
``Exchange Act'')), the securities of which are registered under
Section 12 of the Exchange Act, or that are required to file reports
under the Exchange Act or that file or have filed registration
statements that have not yet become effective under the Securities
Act of 1933 (the ``Securities Act''), and that have not been
withdrawn).
    \23\ See Sarbanes-Oxley Act, supra footnote 21, at Title I Sec.
101(c)(2).
    \24\ The federal securities laws for this purpose are the
Securities Act, the Exchange Act, the Sarbanes-Oxley Act, the Trust
Indenture Act of 1939, the Investment Company Act, the Advisers Act,
and the Securities Investor Protection Act of 1970, and the rules,
regulations and Commission orders thereunder. See PCAOB rule
1001(s)(ii); section 3(a)(47) of the Exchange Act.
    \25\ The Commission adopted rule 30a-3 and a number of other
rules in order to implement certain certification requirements of
the Sarbanes-Oxley Act, supra footnote 21, that are applicable to
companies filing reports under section 13(a) or 15(d) of the
Exchange Act, and to extend those requirements to all registered
management investment companies other than small business investment
companies registered on Form N-5. See Certification of Management
Investment Company Shareholder Reports and Designation of Certified
Shareholder Reports as Exchange Act Periodic Reporting Forms;
Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley
Act, Investment Company Act Release No. 25914 (Jan. 27, 2003)
(adopting Investment Company Act rule 30a-3); Management's Report on
Internal Control Over Financial Reporting and Certification of
Disclosure in Exchange Act Periodic Reports, Investment Company Act
Release No. 26068 (June 5, 2003) (amending rule 30a-3). See also
Certification of Disclosure in Companies' Quarterly and Annual
Reports, Investment Company Act Release No. 25722 (Aug. 30, 2002)
(adopting Exchange Act rules 13a-15 and 15d-15 to require that
certain Exchange Act filers have disclosure controls and procedures
in order ``to assist principal executive and financial officers in
the discharge of their responsibilities in making the required
certifications, as well as to discharge their responsibilities in
providing accurate and complete information to security holders'').
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    Second was the adoption in 2003 of compliance rules under the
Investment Company Act and the Advisers Act (together, the ``Compliance
Rules'').\26\ The Compliance Rules were designed to enhance compliance
with the federal securities laws by requiring funds and advisers to
adopt and implement written compliance policies and procedures that are
reasonably designed to prevent violation of the federal securities
laws, to review those policies and procedures annually for their
adequacy and the effectiveness of their implementation, and to
designate a chief compliance officer (``CCO'') to be responsible for
administering them.\27\ Of particular relevance, the Commission stated
that rule 38a-1 requires a fund to adopt compliance policies and
procedures with respect to fair value that require the fund to:
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    \26\ 17 CFR 270.38a-1 and 17 CFR 275.206(4)-7. See also
Compliance Programs of Investment Companies and Investment Advisers,
Investment Company Act Release No. 26299 (Dec. 17, 2003)
(``Compliance Rules Adopting Release'').
    \27\ Investment Company Act rule 38a-1 provides that the
policies and procedures must be reasonably designed to prevent
violations of the federal securities laws (as defined in the rule),
and Advisers Act rule 206(4)-7 provides that the policies and
procedures must be reasonably designed to prevent violations of the
Advisers Act and the rules thereunder.
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    1. Monitor for circumstances that may necessitate the use of fair
value;
    2. establish criteria for determining when market quotations are no
longer reliable for a particular portfolio security;
    3. provide a methodology or methodologies by which the fund
determines fair value; and
    4. regularly review the appropriateness and accuracy of the
methodology used to determine fair value, and make any necessary
adjustments.\28\
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    \28\ Compliance Rules Adopting Release, supra footnote 26, at
section II.A.2.c.
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    Third was the issuance and codification by the Financial Accounting
Standards Board (``FASB'') of ASC Topic 820 in 2006 and 2009.\29\ ASC
Topic 820 defines the term ``fair value'' for purposes of the
accounting standards \30\ and establishes a framework for the
recognition, measurement, and disclosure of fair value under U.S.
generally-accepted accounting principles (``U.S. GAAP'').\31\
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    \29\ The FASB issued Fair Value Measurements, Statement of
Financial Accounting Standards No. 157 (``SFAS No. 157''), in
September 2006, and codified it in 2009 as ASC Topic 820.
    \30\ See supra footnote 13 (describing the difference between
what ``fair value'' means under the Investment Company Act and under
ASC Topic 820).
    \31\ Id. Rule 4-01(a)(1) of Regulation S-X [17 CFR 210.4-
01(a)(1)] states that ``[f]inancial statements filed with the
Commission which are not prepared in accordance with generally
accepted accounting principles will be presumed to be misleading or
inaccurate, despite footnote or other disclosures, unless the
Commission has otherwise provided.''
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    Taken together, we believe these regulatory developments have
significantly altered the framework in which funds, boards, fund
investment advisers, other fund service providers such as pricing
services, and auditors perform various functions relating to fair value
determinations. We believe that today determining fair value often
requires greater resources and expertise than when the Commission
issued ASR 113 and ASR 118 roughly fifty years ago. In addition, we
believe that regulatory changes during that period have altered the way
that boards, fund investment advisers, other fund service providers,
and auditors address valuation. Our views are also informed by
significant outreach that the staff has conducted with funds,
investment advisers, audit firms, trade groups, fund directors, and
others, particularly over the past two years. As part of these
discussions, many boards sought additional clarity on how they can
effectively fulfill their fair value determination obligations while
seeking the assistance of others. The staff understands that this is of
particular focus in light of the increased complexity of many fund
portfolios and the in-depth expertise required to accurately fair value
such complex investments.
    In recognition of these changes, we are proposing a new rule to
reflect the increased role that subsequent accounting and auditing
developments play in setting fund fair value practices, as well as the
growing complexity of valuation and the interplay of the compliance
rule in facilitating board oversight of funds. The proposed rule also
acknowledges the important role that fund investment advisers now play
and expertise they now provide in the fair value determination process
given these and other developments.

II. Discussion

    The proposed rule would provide requirements for determining fair
value in good faith with respect to a fund for purposes of section
2(a)(41) of the Act and rule 2a-4 thereunder.\32\ We believe that, in
light of the developments discussed above, to determine the fair value
of fund investments in good faith requires a certain minimum,
consistent framework for fair value and standard of baseline practices
across funds, which would be established by the proposed rule. The
proposed rule would also permit a fund's board to assign fair value
determinations to an investment adviser of the fund.\33\ Permitting a
fund's board to assign fair value determinations to an investment
adviser is designed to recognize the developments discussed above,
including the important role that fund investment advisers now play and
expertise they now provide in the fair value determination process,
given these developments. However, when a fund's board uses the
services of a fund investment adviser as part of the fair value
determination process, we believe it is particularly important to
establish a framework for boards to effectively oversee the investment
adviser through the proposed rule, in light of the adviser's conflicts
of interest and given that, in these circumstances, the fund's board
would satisfy its statutory obligation to determine fair value in good
faith through the framework of the proposed rule, including this board
oversight.
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    \32\ The rule would define ``fund'' as a registered investment
company or a business development company. Proposed rule 2a-5(e)(1).
    \33\ For purpose of the proposed rule, ``board'' means either
the fund's entire board of directors or a designated committee of
such board composed of a majority of directors who are not
interested persons of the fund. Proposed rule 2a-5(e)(3).
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    Accordingly, under the proposed rule, fair value as determined 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 any pricing services used; adopting and implementing
policies and procedures; and maintaining certain records.\34\ These
required functions generally reflect our understanding of current
practices used by funds to fair value their investments and we discuss
each in detail below. When a board assigns the determination of fair
value to an adviser for some or all of the fund's investments under the
proposed rule, in addition to board oversight, the rule would include
certain reporting, recordkeeping, and other requirements designed to
facilitate the board's oversight of the adviser's fair value
determinations.\35\
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    \34\ Proposed rule 2a-5(a).
    \35\ Proposed rule 2a-5(b).
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    The proposed rule would apply to all registered investment
companies and BDCs, regardless of their classification or sub-
classification (e.g., open-end funds and closed-end funds, including
BDCs \36\), or their investment objectives or strategies (e.g., equity
or fixed income; actively managed or tracking an index).\37\ In the
case of a unit investment trust (``UIT''), because a UIT does not have
a board of directors or investment adviser, a UIT's trustee would
conduct fair value determinations under the proposed rule.\38\
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    \36\ An open-end fund is a management investment company that
offers for sale or has outstanding redeemable securities of which it
is the issuer. See section 5(a)(1) of the Investment Company Act. A
closed-end fund is a management investment company other than an
open-end fund. See section 5(a)(2) of the Investment Company Act.
Section 2(a)(48) of the Investment Company Act defines a ``business
development company'' as any closed-end investment company that
operates for the purpose of making investments in securities
described in section 55(a)(1) through 55(a)(3) of the Investment
Company Act and that makes available significant managerial
assistance with respect to the issuers of such securities.
    \37\ See proposed rule 2a-5(e)(1) (defining ``fund'' to mean a
registered investment company or business development company).
    \38\ Proposed rule 2a-5(d). Section 4(2) of the Investment
Company Act defines a UIT as an investment company that (1) is
organized under a trust indenture or similar instrument, (2) does
not have a board of directors, and (3) issues only redeemable
securities, each of which represents an undivided interest in a unit
of specified securities. But see Form N-7 for Registration of Unit
Investment Trusts under the Securities Act of 1933 and the
Investment Company Act of 1940, Investment Company Act Release No.
15612, Appendix B, Guide 2, [52 FR 8268, 8295-96 (Mar. 17, 1987)]
(Staff Guidelines stating that the board's fair value role under
section 2(a)(41) is to be performed by the UIT's trustee or the
trustee's appointed person). See infra section II.D (rescission of
staff guidance).
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    We are also proposing to rescind ASR 113 and 118, which provide
guidance on, among other things, the role of the fund board in fair
value determinations as well as guidance on certain accounting and
auditing matters. In addition, the staff letters related to the board
role in the fair value process would be withdrawn as discussed in
section II.E below.\39\
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    \39\ The staff's review will include, but will not necessarily
be limited to, the letters identified in that section.
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A. Fair Value as Determined in Good Faith Under Section 2(a)(41) of the
Act

    We discuss below each of the required functions set forth in
proposed rule 2a-5(a) that must be performed to determine in good faith
the fair value of the fund's investments.\40\
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    \40\ These requirements would apply to a fund's board that is
determining fair value or, if the board assigns any fair value
determinations to an adviser as discussed below, to that adviser.
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1. Valuation Risks
    Proposed rule 2a-5 would provide that determining fair value in
good faith requires periodically assessing any material risks
associated with the determination of the fair value of the fund's
investments, including material conflicts of interest, and managing
those identified valuation risks.\41\ We believe that assessing and
managing identified valuation risks is an important element for
determining fair value in good faith because ineffectively managed
valuation risks can make it more likely that a board or an adviser may
incorrectly value an investment.
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    \41\ Proposed rule 2a-5(a)(1). Valuation risk includes the risks
associated with the process of determining whether an investment
must be fair valued in the first place.
---------------------------------------------------------------------------

    There are many potential sources of valuation risk. A non-
exhaustive list of the types or sources of valuation risk includes:
     The types of investments held or intended to be held by
the fund;
     potential market or sector shocks or dislocations; \42\
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    \42\ Potential indicators of market or sector shocks or
dislocations could include a significant change in short-term
volatility or market liquidity, significant changes in trading
volume, or a sudden increase in trading suspensions.
---------------------------------------------------------------------------

     the extent to which each fair value methodology uses
unobservable inputs, particularly if such inputs are provided by the
adviser; \43\
---------------------------------------------------------------------------

    \43\ See infra footnotes 209-210 and accompanying text.
---------------------------------------------------------------------------

     the proportion of the fund's investments that are fair
valued as determined in good faith, and their contribution to the
fund's returns;
     reliance on service providers that have more limited
expertise in relevant asset classes; the use of fair value
methodologies that rely on inputs from third party service providers;
and the extent to which third party service providers rely on their own
service providers (so-called ``fourth party'' risks); and
     the risk that the methods for determining and calculating
fair value are inappropriate or that such methods are not being applied
consistently or correctly.
    Other than material conflicts of interest, the proposed rule does
not identify the specific valuation risks to be addressed under this
requirement. Rather, we believe that specific valuation risks would
depend on the facts and circumstances of a particular fund's
investments. The proposed rule also does not include a specific
frequency for the required periodic re-assessment of a fund's valuation
risks, as we believe that different frequencies may be appropriate for
different funds or risks. We believe that the periodic re-assessment of
valuation risk generally should take into account changes in fund
investments, significant changes in a fund's investment strategy or
policies, market events, and other relevant factors.
    We request comment on the proposal to require the assessment and
management of the material risks associated with fair value
determinations.
    1. Is this requirement appropriate? Should we further define what
risks would need to be considered or provide guidance on the types of
valuation risks that a fund may face? Are there additional sources or
types of valuation risk that we should address? If so, what sources?
    2. Should we require a certain minimum frequency for re-assessing
valuation risk (e.g., annually or quarterly)? Should the rule specify
types of market events or investment strategy changes that would
require a re-assessment of valuation risk? If so, what events or
changes should prompt such a review?
    3. Should we provide any further guidance on how valuation risk
should be managed?
2. Fair Value Methodologies
    Proposed rule 2a-5 would provide that fair value as determined in
good faith requires selecting and applying in a consistent manner an
appropriate methodology or methodologies \44\ for

determining (which includes calculating) the fair value of fund
investments. This requirement would include specifying (1) the key
inputs and assumptions specific to each asset class or portfolio
holding, and (2) the methodologies that will apply to new types of
investments in which the fund intends to invest.\45\ The proposed rule
also would require the selected methodologies to be periodically
reviewed for appropriateness and accuracy, and to be adjusted if
necessary. Selecting and applying a methodology consistently--and
reviewing the methodology and adjusting it if necessary--are all
important elements to determining fair value in good faith.\46\ This is
because an inappropriate methodology, or a methodology that is applied
inconsistently, increases the likelihood that a fund's investments will
be improperly valued.
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    \44\ ASC Topic 820 refers to valuation approaches and valuation
techniques. In practice, many valuation techniques are referred to
as methods (e.g., discounted cash flow method). As a result, this
release uses the terms ``technique'' and ``method'' interchangeably
to refer to a specific way of determining fair value and likewise
uses the terms ``methods'' and ``methodologies'' interchangeably.
    \45\ Proposed rule 2a-5(a)(2). Regarding the key inputs and
assumptions specific to each asset class or portfolio holding, it
would not be sufficient, for example, to simply state that private
equity investments are valued using a discounted cash flow model, or
that options are valued using a Black-Scholes model, without
providing any additional detail on the specific qualitative and
quantitative factors to be considered, the sources of the
methodology's inputs and assumptions, and a description of how the
calculation is to be performed (which may, but need not necessarily,
take the form of a formula).
    \46\ Different methodologies may be appropriate for different
asset classes. Accordingly, this requirement would not require that
a single methodology be applied in all cases, but instead that any
methodologies selected be applied consistently to the asset classes
for which they are relevant.
---------------------------------------------------------------------------

    Currently, ASC Topic 820 refers to valuation approaches, including
the market approach, income approach, and cost approach, as well as
valuation techniques and methods as ways in which to measure fair
value.\47\ To be appropriate under the rule, and in accordance with
current accounting standards, a methodology used for purposes of
determining fair value must be consistent with ASC Topic 820, and thus
derived from one of these approaches. We recognize, however, that there
is no single methodology for determining the fair value of an
investment because fair value depends on the facts and circumstance of
each investment, including the relevant market and market
participants.\48\
---------------------------------------------------------------------------

    \47\ See supra footnote 44.
    \48\ See ASR 118 (``Methods which are in accord with this
principle may, for example, be based on a multiple of earnings, or a
discount from market of a similar freely traded security, or yield
to maturity with respect to debt issues, or a combination of these
and other methods.''). Consistent with the principles in ASC Topic
820, under the proposal, the methodologies selected should maximize
the use of relevant observable inputs and minimize the use of
unobservable inputs.
---------------------------------------------------------------------------

    Proposed rule 2a-5 also would require that the board or adviser
consider the applicability of the selected fair value methodologies to
types of fund investments that a fund does not currently hold but in
which it intends to invest in the future.\49\ This requirement is
designed to facilitate the effective determination of the fair value of
these new investments by the board or adviser. In addition, the
proposed rule would require periodic reviews of the selected fair value
methodologies for appropriateness and accuracy, and adjustments to the
methodologies where necessary. For example, the results of back-testing
or calibration (as discussed below) or a change in circumstances
specific to an investment could necessitate adjustments to a fund's
fair value methodologies.\50\ As discussed above, while the proposed
rule would require that the fair value methodologies be consistently
applied to the asset classes for which they are relevant, there can be
circumstances where it is appropriate to adjust methodologies if the
adjustments would result in a measurement that is equally or more
representative of fair value.\51\ The proposed rule's requirement to
apply fair value methodologies in a consistent manner would not
preclude the board or adviser from changing the methodology for an
investment in such circumstances.\52\
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    \49\ Proposed rule 2a-5(a)(2)(i). For example, the board or
adviser, as applicable, generally should address, prior to the
fund's investing in a new type of investment, whether readily
available market quotations will be used or if the investment may
need to be fair valued on occasion or at all times. For certain
types of investments, it should be clear that the asset will require
a fair value at all times. For others, however, market quotations
may sometimes be readily available and sometimes not, so that
periodically a fair value will need to be determined. The board or
adviser generally should seek to identify sources of price inputs
before the fund invests in such asset classes, if possible, in
addition to determining an appropriate fair value methodology, and
generally should document these decisions.
    \50\ Proposed rule 2a-5(a)(2)(ii). ASC Topic 820-10-35-25
provides a non-exhaustive list of events that may warrant a change
or an adjustment to a valuation technique, including where (1) new
markets develop, (2) new information becomes available, (3)
information previously used is no longer available, (4) the
valuation technique improves, and (5) market conditions change.
Boards or advisers generally should seek to account for such
occurrences and consider specifying alternative sources.
    \51\ See ASC Topic 820-10-35-25.
    \52\ Records supporting any such methodology changes would be
required to be maintained under the proposed recordkeeping
provisions. See proposed Rule 2a-5(a)(6).
---------------------------------------------------------------------------

    The proposed rule also would require the board or adviser to
monitor for circumstances that may necessitate the use of fair value as
determined in good faith.\53\ The use of fair value is required when
market quotations are not readily available. The rule would require the
establishment of criteria for determining when market quotations no
longer are reliable, and therefore are not readily available.\54\ For
example, if a fund invests in securities that trade in foreign markets,
the board or adviser generally should identify and monitor for the
kinds of significant events that, if they occurred after the market
closes in the relevant jurisdiction but before the fund prices its
shares, would materially affect the value of the security and therefore
may suggest that market quotations are not reliable.\55\
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    \53\ Proposed rule 2a-5(a)(2)(iii). As discussed below, we are
also proposing to define when market quotations are readily
available for purposes of section 2(a)(41).
    \54\ Proposed rule 2a-5(a)(2)(iv).
    \55\ See ASC Topic 820-10-35-41C(b).
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    We continue to believe that for any particular investment there may
be a range of appropriate values that could reasonably be considered to
be fair value, and whether a specific value should be considered fair
value will depend on the facts and circumstances of the particular
investment. Accordingly, we expect that the methodologies used may
reflect this range of potential fair values and result in unbiased
determinations of fair value within the range.
    We request comment on the proposed requirement to establish and
apply the methodologies for determining and calculating fair value.
    4. This requirement includes several specified elements, discussed
above, relating to the fair value methodologies. Are these elements
appropriate? Are there additional elements that commenters believe
should be included under this requirement? Should we modify or remove
any of the proposed elements? Should we require application of the
methodologies in a reasonably consistent manner, or as consistently as
possible under the circumstances?
    5. Do commenters believe we should provide additional guidance
relating to this requirement? If so, on which elements of the proposed
requirement should we provide additional guidance? For example, is the
proposed requirement that boards or advisers ``select'' a methodology
sufficiently clear?
    6. Are there investments for which it is not feasible to establish
a methodology in advance? If so, how should the rule address such
situations? Is it clear what new investment types a

fund may ``intend'' to invest in? Should we provide any further
guidance on this? What processes do funds currently follow before
investing in new types of investments to help to ensure that, after
making the investment, the board will be in a position to determine
fair value if required?
3. Testing of Fair Value Methodologies
    The proposed rule would require the testing of the appropriateness
and accuracy of the methodologies used to calculate fair value.\56\
This requirement is designed to help ensure that the selected fair
value methodologies are appropriate and that adjustments to the
methodologies are made where necessary. We believe that the specific
tests to be performed and the frequency with which such tests should be
performed are matters that depend on the circumstances of each fund and
thus should be determined by the board or the adviser. The proposed
rule would require the identification of (1) the testing methods to be
used, and (2) the minimum frequency of the testing.\57\ We believe that
the results of calibration and back-testing can be particularly useful
in identifying trends, and also have the potential to assist in
identifying issues with methodologies applied by fund service
providers, including poor performance or potential conflicts of
interest.\58\ For example, if a specific methodology consistently over-
values or under-values one or more fund investments as compared to
observed transactions, the board or adviser should investigate the
reasons for this difference. We recognize, however, that back-testing
may be less useful for portfolio holdings that trade infrequently.\59\
---------------------------------------------------------------------------

    \56\ Proposed rule 2a-5(a)(3).
    \57\ Id. Calibration can assist in assessing whether the fund's
valuation technique reflects current market conditions, and also
whether any adjustments to the valuation technique are appropriate.
``Calibration'' for these purposes is the process for monitoring and
evaluating whether there are material differences between the actual
price the fund paid to acquire portfolio holdings that received a
fair value under the Act and the prices calculated for those
holdings by the fund's fair value methodology at the time of
acquisition.
    \58\ Back-testing involves a comparison of the fair value
ascribed to the fund's investment against observed transactions or
other market information, such as quotes from dealers or data from
pricing services. One common form of back-testing is ``disposition
analysis,'' which compares a fair value as determined using a fair
value technique with the price obtained for the security upon its
disposition by the fund.
    \59\ See In re Morgan Asset Management, supra footnote 9 (back-
testing by the fund ``only covered securities after they were sold;
thus, at any given time, the Valuation Committee never knew how many
securities' prices could ultimately be validated by it.'').
---------------------------------------------------------------------------

    We request comment on the proposed rule's requirement to test the
appropriateness and accuracy of the fair value methodologies.
    7. Should the rule require particular testing types or minimum
testing frequencies? For example, should we require tests to occur at
least weekly, monthly, or quarterly? If so, should the frequency
required be dependent upon the type of instrument? Should the rule
require all funds to use certain types of testing, such as back testing
and calibration, at a minimum? Are certain types of methodology testing
inappropriate or irrelevant for certain investment types?
    8. What other types of testing of fair value methodologies are
commonly used?
    9. Should the rule require specified actions based on the results
of the testing? If so, what would those actions be?
4. Pricing Services
    To obtain valuation information, particularly for thinly traded or
more complex assets, pricing services, may be used. Pricing services
are third-parties that regularly provide funds with information on
evaluated prices, matrix prices, price opinions, or similar pricing
estimates or information to assist in determining the fair value of
fund investments.\60\ Accordingly, the proposed rule would provide that
determining fair value in good faith requires the oversight and
evaluation of pricing services, where used.\61\ This provision is
designed to help ensure that pricing information received from pricing
services serves as a reliable input for determining fair value in good
faith.
---------------------------------------------------------------------------

    \60\ See 2014 Money Market Fund Release, supra footnote 14, at
section III.D.2.b.
    \61\ Proposed rule 2a-5(a)(4).
---------------------------------------------------------------------------

    For funds that use pricing services, the proposed rule would
require that the board or adviser establish a process for the approval,
monitoring, and evaluation of each pricing service provider. The board
or adviser generally should take into consideration factors such as (i)
the qualifications, experience, and history of the pricing service;
(ii) the valuation methods or techniques, inputs, and assumptions \62\
used by the pricing service for different classes of holdings, and how
they are affected as market conditions change; (iii) the pricing
service's process for considering price ``challenges,'' \63\ including
how the pricing service incorporates information received from pricing
challenges into its pricing information; (iv) the pricing service's
potential conflicts of interest and the steps the pricing service takes
to mitigate such conflicts; and (v) the testing processes used by the
pricing service.
---------------------------------------------------------------------------

    \62\ In considering a pricing service's valuation methods or
techniques, inputs, and assumptions, the fair value policies and
procedures generally should address whether the pricing service is
relying on inputs or assumptions provided by the adviser.
    \63\ Price challenges involve, for example, the fund disagreeing
with an evaluated price provided by a pricing service and providing
additional information to the service suggesting that the provided
evaluated price is not correct.
---------------------------------------------------------------------------

    In addition, there may be times when pricing information from a
pricing service differs materially from the board's or adviser's view
of the fair value of the investment, and the board or adviser may seek
to contact the pricing service to question the basis for the pricing
information. As such, the proposed rule would require the establishment
of criteria for the circumstances under which price challenges
typically would be initiated (e.g., establishing objective thresholds).
    We request comment on the proposed rule's requirement to oversee
pricing services.
    10. Do commenters agree that the proposed rule should require
oversight of pricing service providers, if used? Should the rule cover
any service providers other than pricing services? If so, which service
providers should be included? Should the rule further clarify who
qualifies as a pricing service?
    11. Should there be a specific requirement in the rule to
periodically review the selection of the pricing services used and to
evaluate other pricing services?
5. Fair Value Policies and Procedures
    Proposed rule 2a-5 would require written policies and procedures
addressing the determination of the fair value of the fund's
investments (``fair value policies and procedures'').\64\ The proposed
rule would require the fair value policies and procedures to be
reasonably designed to achieve compliance with the requirements of
proposed rule 2a-5 discussed above. Requiring fair value policies and
procedures that would be tailored to the proposed rule's requirements
would help to ensure that a board or adviser, as applicable, determines
the fair value of fund investments in compliance with the rule. Under
the proposed rule, where the board determines the fair value of
investments, the board-approved fair value policies and procedures
would be adopted and implemented by the fund. Where the

board assigns fair value determinations to the adviser under proposed
rule 2a-5(b), as discussed in section II.B, the fair value policies and
procedures would be adopted and implemented by the adviser, subject to
board oversight under rule 38a-1.\65\
---------------------------------------------------------------------------

    \64\ Proposed rule 2a-5(a)(5).
    \65\ Proposed rule 2a-5(b).
---------------------------------------------------------------------------

    Rule 38a-1 also would apply to a fund's obligations under the
proposed rule. Rule 38a-1 requires a fund's board, including a majority
of its independent directors, to approve the fund's policies and
procedures, including those on fair value, and those of each investment
adviser and other specified service providers, based upon a finding by
the board that the policies and procedures are reasonably designed to
prevent violation of the federal securities laws.\66\ Rule 38a-1 also
requires that the fund's CCO provide an annual report to the fund's
board \67\ that must address any material changes to compliance
policies and procedures.\68\ Rule 38a-1 would encompass a fund's
compliance obligations with respect to proposed rule 2a-5, if adopted,
and would require a fund's board to oversee compliance with the
rule.\69\ To the extent that adviser policies and procedures under
proposed rule 2a-5 would otherwise be duplicative of fund valuation
policies under rule 38a-1,\70\ a fund could adopt the rule 2a-5
policies and procedures of the adviser in fulfilling its rule 38a-1
obligations.
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    \66\ Rule 38a-1(a)(2).
    \67\ For UITs, the fund's principal underwriter or depositor
conducts the functions assigned to management company boards under
rule 38a-1. Rule 38a-1(b). This would continue if we adopt the
proposed rule.
    \68\ See rule 38a-1(a)(4)(iii)(A). See also Compliance Rules
Adopting Release, supra footnote 26, at n.33. ``Material'' in this
context is a change that a fund director would reasonably need to
know in order to oversee fund compliance. See rule 38a-1(e)(2). We
have also said that ``serious compliance issues'' must be raised
with the board immediately. See Compliance Rules Adopting Release,
supra footnote 26, at n.33.
    \69\ If adopted, rule 2a-5's requirements would supersede the
Compliance Rules Adopting Release's discussion of specific policies
and procedures required regarding the pricing of portfolio
securities and fund shares. Cf. Compliance Rules Adopting Release,
supra footnote 26, at nn.39-47 and accompanying text.
    \70\ See generally footnote 108.
---------------------------------------------------------------------------

    We request comment on the proposed fair value policies and
procedures requirement.
    12. Are there specific elements that the proposed fair value
policies and procedures should include other than the required elements
of proposed rule 2a-5(a)?
    13. Are we sufficiently clear on the interaction between rule 38a-1
and the policies and procedures under proposed rule 2a-5? Should we
provide any further guidance on their interaction?
6. Recordkeeping
    Proposed rule 2a-5 would require that the fund maintain certain
records.\71\ Specifically, the proposed rule would require the
maintenance of:
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    \71\ Proposed rule 2a-5(a)(6). Under the proposed rule, the fund
would maintain the required records both where the board itself
determines the fair value of investments and where it assigns fair
value determinations to an adviser under proposed rule 2a-5(b), as
discussed at infra section II.B.6.
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     Supporting Documentation. Appropriate documentation to
support fair value determinations, including information regarding the
specific methodologies applied and the assumptions and inputs
considered when making fair value determinations, as well as any
necessary or appropriate adjustments in methodologies, for at least
five years from the time the determination was made, the first two
years in an easily accessible place; and
     Policies and Procedures. A copy of policies and procedures
that would be required under the proposed rule that are in effect, or
that were in effect at any time within the past five years, in an
easily accessible place.
    Funds and advisers currently are required to retain certain
documentation related to fund valuation.\72\ Documents often provide
the primary means to demonstrate whether portfolio holdings have been
valued in a manner consistent with applicable law, any valuation
compliance policies and procedures, and any disclosures. They also
provide evidence to the fund's auditors in performing their duties
related to the audit of the fund's financial statements and assist the
fund's CCO in the preparation of compliance reports to the board. The
Commission has brought enforcement actions in cases where it alleged
that appropriate documentation relating to valuation was not maintained
by a fund or adviser or obtained by auditors.\73\
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    \72\ Rule 38a-1(d) requires the maintenance of certain records,
including copies of: All compliance policies and procedures adopted
by the fund that are in effect or were in effect at any time during
the last five years; materials provided to the board in connection
with their approval of fund and service provider policies and
procedures under the rule; the CCO's annual report to the board; and
any records documenting the board's annual review of fund and
service provider compliance policies and procedures under the rule.
Rule 204-2 under the Advisers Act similarly requires an adviser to
maintain copies of the adviser's compliance policies and procedures
that are in effect or were in effect at any time during the last
five years and any records documenting its annual review of such
policies and procedures. See 17 CFR 275.204-2. See also Compliance
Rules Adopting Release, supra footnote 26, at section II.D. The
funds' and advisers' records may be retained electronically. See id.
(discussing rule 31a-2(f) under the Investment Company Act and rule
204-2(g) under the Advisers Act).
     Other provisions of the federal securities laws require, among
other things, that registered investment companies maintain
appropriate books and records in support of the fund's financial
statements and preserve for a specified period (generally six years)
all schedules evidencing and supporting each computation of NAV. See
Investment Company Act section 31(a) and rules 31a-1 and 31a-2. In
addition, funds reporting under the Exchange Act must make and keep
books, records, and accounts that accurately and fairly reflect
their transactions and dispositions of their assets in reasonable
detail. 15 U.S.C. 78m(b)(2)(A).
    \73\ See In re Allied Capital Corp., Securities Exchange Act
Release No. 55931 (June 20, 2007) (settlement) (fund failed to
maintain documentation required under the Exchange Act). See also In
the Matter of Carroll A. Wallace, Securities Exchange Act Release
No. 48372 (Aug. 20, 2003) (Commission opinion) (partner of
accounting firm engaged in improper professional conduct in
recklessly failing to obtain sufficient competent evidential
material to support statements in the auditors' reports); In the
Matter of Morgan Stanley, Securities Exchange Act Release No. 50632
(Nov. 4, 2004) (settlement) (financial services firm failed to
maintain sufficient underlying documentation supporting certain
valuations).
---------------------------------------------------------------------------

    The proposed requirement to maintain appropriate documentation to
support fair value determinations would include documentation that
would be sufficient for a third party to verify the fair value
determination. We understand that advisory personnel currently produce
working papers supporting fair value determinations that include, for
example, calibration and back-testing data as well as other information
such as stale price analysis.\74\ These records would be required to be
maintained as supporting fair value determinations.\75\
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    \74\ Stale price analysis can include an evaluation of whether a
price quote that may be used to support a fair value price is
sufficiently timely to be useful.
    \75\ Proposed rule 2a-5(a)(6)(i).
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    We believe that it is appropriate for the proposed rule to include
a recordkeeping provision to facilitate compliance with the proposed
rule and to permit effective regulatory oversight. The proposed
retention periods are designed to be consistent with the recordkeeping
requirements in rule 38a-1(d), the compliance rule. As discussed above,
the compliance rule requires the retention of, among other things,
compliance policies and procedures (which would include those relating
to valuation) and certain records.\76\ We believe that this
recordkeeping requirement would provide important investor protections
and, because it would be consistent with current record retention
practices under to rule 38a-1(d), would not impose overly burdensome
recordkeeping costs.
---------------------------------------------------------------------------

    \76\ See supra footnote 72.
---------------------------------------------------------------------------

    We request comment on the proposed recordkeeping provisions.

    14. Are there any additional types of records that we should
require? If so, which records and why?
    15. Where the board assigns fair value determinations to an adviser
under proposed rule 2a-5(b), should the rule require the adviser,
rather than the fund, to maintain these records?
    16. Are the proposed retention periods sufficient to evidence
compliance? Why or why not? Should we require a longer (e.g., six
years) or shorter (e.g., four years) retention period?
    17. Are key terms used in this aspect of the proposal sufficiently
understandable? For example, as stated above, ``appropriate
documentation to support fair value determinations'' under the proposed
recordkeeping requirement would include documentation that would be
sufficient for a third party to verify the fair value determination.
Should we define these or other terms or provide further guidance
relating to them?

B. Performance of Fair Value Determinations

    The Act assigns boards a critical role in connection with
determinations of fair value.\77\ Although the Commission has
previously taken the position that a fund's board may not delegate the
determination of fair value to anyone else,\78\ the Commission has also
recognized that compliance with the Act does not require the board to
perform each of the specific tasks required to calculate fair value
itself.\79\ We believe that the Commission's prior guidance recognized
that determinations of fair value often require significant resources
and specialized expertise, and that in many cases it may be
impracticable for directors themselves to perform every one of the
necessary tasks without assistance. We expect that today determining
fair value requires even greater resources and expertise than when ASR
113 and ASR 118 were issued. For this reason, in addition to providing
requirements for determining fair value in good faith generally, the
proposed rule also is designed to provide boards and advisers with a
consistent, modern approach to the allocation of fair value functions,
while also preserving a crucial role for boards to fulfill their
obligations under section 2(a)(41) of the Act.
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    \77\ Section 2(a)(41)(B)(ii) provides that, when market
quotations are not readily available, ``value'' means ``fair value
as determined in good faith by the board of directors.'' Rule 2a-4
contains the same definition of fair value as section
2(a)(41)(B)(ii). 17 CFR 270.2a-4. The Commission has discussed the
board's role in determinations of fair value in a number of
Commission releases, including ASR 113, ASR 118, the Compliance
Rules Adopting Release, supra footnote 26, and the 2014 Money Market
Fund Release, supra footnote 14.
     In addition to their role under the Act, boards may have
liability under antifraud provisions of the federal securities laws
if a fund's prospectus or other disclosures regarding valuation are
not consistent with the fund's valuation practices. See, e.g., 15
U.S.C. 77k(a)(1).
    \78\ See, e.g., 2014 Money Market Fund Release, supra footnote
14, at nn.890 and 896 and accompanying text; In the Matter of
Seaboard Associates, Inc. (Report of Investigation Pursuant to
Section 21(a) of the Exchange Act), Investment Company Act Release
No. 13890 (Apr. 16, 1984) (``The Commission wishes to emphasize that
the directors of a registered investment company may not delegate to
others the ultimate responsibility of determining the fair value of
any asset not having a readily ascertainable market value, such as
oil and gas royalty interests.'').
    \79\ The Commission stated in ASR 118 that the board ``may
appoint persons to assist them in the determination of [fair] value,
and to make the actual calculations pursuant to the board's
direction''; however, ``the findings of such individuals must be
carefully reviewed by the directors in order to satisfy themselves
that the resulting valuations are fair.'' See also ASR 113 (``The
actual calculations may be made by persons acting pursuant to the
direction of the board.'').
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    Under the proposed rule, a board may choose to determine fair value
in good faith for any or all fund investments by carrying out all of
the functions required in paragraph (a) of the proposed rule,
including, among other things, monitoring for circumstances that
necessitate fair value, selecting valuation methodologies, and applying
those methodologies.\80\ However, a board would not be required to take
this approach. We understand that, for practical reasons, few boards
today are directly involved in the performance of the day-to-day
valuation tasks required to determine fair value. Instead they enlist
the fund's investment adviser to perform certain of these functions,
subject to their supervision and oversight.\81\
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    \80\ As discussed above, in this circumstance, the fund would,
on behalf of the board, adopt and implement policies and procedures
and keep records consistent with the requirements of paragraph (a)
of the proposed rule. See proposed rule 2a-5(b).
    \81\ For example, for a fund that issues redeemable securities,
value must be calculated at least once each business day for each
portfolio holding in order to calculate the fund's NAV. 17 CFR
270.22c-1(b)(1). Making these fair value determinations by
themselves would therefore likely be impracticable for most, if not
all, boards of such funds.
---------------------------------------------------------------------------

    This allocation of functions is consistent with the framework
created by the ASRs. We continue to believe that allocating day-to-day
responsibilities to an investment adviser, subject to robust board
oversight, is appropriate and consistent with the requirements of Act.
The proposed rule is designed to provide a consistent framework for
this allocation between boards and advisers, and to provide enhanced
protections which we believe are consistent with the more modern
approaches to fair value and compliance with the federal securities
laws described below.
    Accordingly, the proposed rule would permit a fund's board of
directors to assign the fair value determination relating to any or all
fund investments to an investment adviser of the fund, which would
carry out all of the functions required in paragraph (a) of the
proposed rule, subject to certain requirements enumerated in proposed
paragraph (b).\82\ A fund's board could make this assignment to a
fund's primary adviser or one or more sub-advisers. For example, for a
fund with a sub-adviser responsible for managing a portion of the
fund's portfolio, the board could assign the determination of fair
value for the investments in that portion of the fund's portfolio to
that sub-adviser. As a result, a multi-manager fund could have multiple
advisers assigned the role of determining fair value of the different
investments that those advisers manage. Where the board assigns fair
value determinations to multiple advisers, the fund's policies and
procedures adopted under rule 38a-1 should address the added
complexities of overseeing multiple assigned advisers in order to be
reasonably designed to avoid violating the federal securities laws.\83\
Any board assignment under the proposed rule would be subject to board
oversight and certain reporting, recordkeeping, and other requirements
designed to facilitate the board's ability effectively to oversee the
adviser's fair value determinations. We discuss each of these
requirements below.
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    \82\ As noted above, because a UIT does not have a board of
directors or an investment adviser, a UIT's trustee would conduct
fair value determinations under the proposed rule. See proposed rule
2a-5(d). See also supra footnote 38.
    \83\ See rule 38a-1. These challenges include, for example, how
to address reconciling differing opinions on the same investment (if
applicable) and establishing clear reporting structures.
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    We request comment generally on the role of the board of directors
when it does not assign the fair value determination to an adviser to
the fund.
    18. For boards that elect to conduct fair value determinations
themselves, should we provide any guidance on the level of assistance
they can receive from service providers, while fulfilling their
obligations under section 2(a)(41)? Do we need to provide any guidance
on how a board should obtain and oversee such assistance if needed? If
so, what guidance should we provide?

1. Board Oversight
    Where the board assigns fair value determinations to an adviser,
the proposed rule would require the board to satisfy its statutory
obligation with respect to such determinations by overseeing the
adviser. Boards should approach their oversight of fair value
determinations assigned to an investment adviser of the fund with a
skeptical and objective view that takes account of the fund's
particular valuation risks, including with respect to conflicts, the
appropriateness of the fair value determination process, and the skill
and resources devoted to it.\84\ Further, in our view effective
oversight cannot be a passive activity. Directors should ask questions
and seek relevant information. The board should view oversight as an
iterative process and seek to identify potential issues and
opportunities to improve the fund's fair value processes.\85\ The
proposed rule would require the adviser to report to the board with
respect to matters related to the adviser's fair value process, in part
to ensure that the board has sufficient information to conduct this
oversight.\86\ Boards should also request follow up information when
appropriate and take reasonable steps to see that matters identified
are addressed.\87\
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    \84\ See generally Investment Company Governance, Investment
Company Act Release No. 26520 (July 27, 2004) (``Governance
Release'').
    \85\ See, e.g., Derivatives Release, supra footnote 17, at
section II.C.
    \86\ Proposed rule 2a-5(b)(1).
    \87\ For example, we have stated that independent directors
should ``bring to the boardroom `a high degree of rigor and
skeptical objectivity to the evaluation of management and its plans
and proposals,' particularly when evaluating conflicts of
interest.'' See Governance Release, supra footnote 84.
---------------------------------------------------------------------------

    We would expect that boards engaged in this process would use the
appropriate level of scrutiny based on the fund's valuation risk,
including the extent to which the fair value of the fund's investments
depend on subjective inputs. For example, a board's scrutiny would
likely be different if a fund invests in publicly traded foreign
companies than if the fund invests in private early stage companies. As
the level of subjectivity increases and the inputs and assumptions used
to determine fair value move away from more objective measures, we
expect that the board's level of scrutiny would increase
correspondingly.\88\
---------------------------------------------------------------------------

    \88\ For a discussion of fund fair value risks generally, see
supra section II.A.1.
---------------------------------------------------------------------------

    We also believe that, consistent with their obligations under the
Act and as fiduciaries, boards should seek to identify potential
conflicts of interest, monitor such conflicts, and take reasonable
steps to manage such conflicts.\89\ In so doing, the board should serve
as a meaningful check on the conflicts of interest of the adviser and
other service providers involved in the determination of fair
values.\90\ In particular, the fund's adviser may have an incentive to
improperly value fund assets in order to increase fees, improve or
smooth reported returns, or comply with the fund's investment policies
and restrictions.\91\ Other service providers, such as pricing services
or broker-dealers providing opinions on prices, may have incentives
(such as maintaining continuing business relationships with the
adviser) or may otherwise be subject to pressures to provide pricing
estimates that are favorable to the adviser.\92\ In overseeing the
adviser's process for making fair value determinations, the board
should understand the role of, and inquire about conflicts of interest
regarding, any other service providers used by the adviser as part of
the process, and satisfy itself that any conflicts are being
appropriately managed.
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    \89\ See, e.g., Governance Release, supra footnote 87 (`` . . .
state law duties of loyalty and care . . . oblige directors to act
in the best interest of the fund when considering important matters
the Act entrusts to them, such as approval of an advisory contract
and the advisory fee.'').
    \90\ See, e.g., id. (``. . . the Act and our rules rely heavily
on fund boards of directors to manage the conflicts of interest that
advisers have with funds they manage.''). See also Division of
Investment Management, SEC, Protecting Investors: A Half Century of
Investment Company Regulation, 252 (1992) (``the [Investment
Company] Act . . . imposes requirements that assume the standard
equipment of a corporate democracy: a board of directors . . . whose
function is to oversee the operations of the investment company and
police conflicts of interest. . . [W]e believe that independent
directors perform best when required to exercise their judgment in
conflict of interest situations''); see also Investment Company
Institute Independent Directors Council, Fair Valuation Series: The
Role of the Board at 10 (2006) (``IDC Role of the Board''),
available at http://www.ici.org/pdf/06_fair_valuation_board.pdf
(``Investment professionals, for example, can be important sources
of information about the value of securities. At the same time,
conflict of interest concerns may be raised when investment
professionals assign fair valuations that dramatically boost a
fund's performance. These concerns may be heightened when the
compensation of the investment professionals is based on the fund's
performance. To address these potential concerns, boards may want to
consider whether investment professionals responsible for managing a
particular fund should have sole or primary authority for
determining securities valuations for that fund.'').
    \91\ See, e.g., Piper, supra footnote 7. For conflicts of the
fund's portfolio manager, see infra footnote 120 and accompanying
text.
    \92\ Cf. In re Morgan Asset Management, supra footnote 9, at 7
(broker-dealer ``induced to provide interim price confirmations that
were lower than the values at which the Funds were valuing certain
bonds, but higher than the initial confirmations that the [broker-
dealer] had intended to provide'').
---------------------------------------------------------------------------

    Boards should probe the appropriateness of the adviser's fair value
processes. In particular, boards should periodically review the
financial resources, technology, staff, and expertise of the assigned
adviser, and the reasonableness of the adviser's reliance on other fund
service providers, relating to valuation.\93\ In addition, boards
should consider the adviser's compliance capabilities that support the
fund's fair value processes, and the oversight and financial resources
made available to the CCO relating to fair value.
---------------------------------------------------------------------------

    \93\ See In re Morgan Asset Management, supra footnote 9 (``the
Valuation Committee left pricing decisions to lower level employees
in Fund Accounting who did not have the training or qualifications
to make fair value pricing determinations'').
---------------------------------------------------------------------------

    Boards should also consider the type, content, and frequency of the
reports they receive. The proposed rule would require reporting to the
board (both periodically and promptly) regarding many aspects of the
adviser's fair value determination process as a means of facilitating
the board's oversight as discussed below. While a board can reasonably
rely on the information provided to it in summaries and other materials
provided by the adviser and other service providers in conducting its
oversight, it is incumbent on the board to request and review such
information as may be necessary to be fully informed of the adviser's
process for determining the fair value of fund investments. Further, if
the board becomes aware of material matters (whether the board
identifies the matter itself or the fund's CCO or adviser or another
party identifies the issue), we believe that in fulfilling its
oversight duty the board must inquire about such matters and take
reasonable steps to see that they are addressed.\94\
---------------------------------------------------------------------------

    \94\ Proposed rule 2a-5(b)(1)(ii).
---------------------------------------------------------------------------

    We request comment on this aspect of the proposal:
    19. Should we permit boards to fulfill the statutory function to
fair value one or more fund investments in good faith by assigning that
fair value determination to an adviser to the fund as described above?
Would the proposed rule change the services provided by advisers with
respect to valuation and, if so, would such a change have any
implications for the board's consideration of the advisory contract
under section 15(c) of the Act (e.g., changes in compensation)? If so,
are there additional responsibilities under the proposed rule for which
advisers would seek additional compensation?

    20. The rule would permit boards to assign the determination of
fair value only to an adviser to the fund. Are there other parties to
which we should permit boards to assign such determinations? For
example, would it be appropriate to allow boards to assign these
determinations to pricing vendors or accounting firms? Are there any
parties that fund boards currently rely upon to help make fair value
determinations that could adequately be relied upon in the same way as
a fund adviser? If we do permit other parties to be assigned the
determination of fair value under the final rule, what safeguards, if
any, should we include to ensure that the determinations of fair value
in good faith are conducted consistent with the proposed rule? For
example, should we only permit assignment to non-advisers if they have
a fiduciary duty to the fund or if they are regulated by the
Commission? Why or why not?
    21. As proposed, the rule would require that an assignment to an
investment adviser cover all elements of paragraph (a) for a given
investment or investments. Should we permit the assignment of
particular elements of paragraph (a) to an investment adviser or
different advisers? If so, what safeguards should we include to ensure
that the determinations of fair value in good faith are conducted
consistent with the proposed rule?
    22. The proposed rule would permit boards to assign the
determination of fair value in good faith to the fund's primary
investment adviser or one or more sub-advisers. Should we allow boards
to assign this process to sub-advisers, or only allow the fund's
primary investment adviser to fulfill this role? Why or why not? Should
we impose any obligations for the adviser to oversee any assigned sub-
adviser? If so, what obligations? For example, should we require in the
rule that a fund must establish reconciliation procedures to address
situations where sub-advisers have differing views on the fair value of
a fund investment?
    23. Should we limit the assignment to a single adviser in order to
minimize the issues relating to having multiple advisers assigned
determinations of fair value under the Act? If so, why? Conversely,
should we require additional safeguards in the case of multiple
assigned advisers? If so, what should they be? For example, should we
require specific policies and procedures or reports, beyond those
already required, or those that would be required, under rule 38a-1 or
the proposed rule?
    24. Should we permit or require anyone other than the trustee of a
UIT to perform the functions described in paragraph (a), such as a
person appointed by the trustee? Should we, for example, allow the
trustee to assign these determinations to the UIT's sponsor, principal
underwriter, or depositor? Would these or any other parties be better
equipped to determine the fair value of investments? If the rule were
to permit the trustee to assign these determinations to another person,
should we require that person to report to the trustee like the adviser
would to a board for management companies? What kind of oversight
responsibilities should the trustee have? Are there other modifications
to the proposed rule that we should make to apply it to UITs given
their unmanaged nature and different governance structure compared to
other funds?
    25. Is our proposed requirement that a board ``oversee'' the
adviser sufficient? Should we prescribe in rule 2a-5 additional steps
to mitigate the risk of conflicts of interest and other issues related
to the fair value process, such as a third party review of the fair
value process, or an attestation by the adviser? If so, what should
those steps be? What additional costs would they add, and who would
bear those costs?
    26. As noted above,\95\ the proposed rule would define ``board'' as
either the fund's entire board of directors or a designated committee
of such board composed of a majority of directors who are not
interested persons of the fund.\96\ Are there any actions required in
the proposed rule that we should require the full board, rather than a
committee, to perform?
---------------------------------------------------------------------------

    \95\ See supra footnote 33.
    \96\ Proposed rule 2a-5(e)(3).
---------------------------------------------------------------------------

    27. Would boards assign the fair value determination to an
investment adviser with respect to some investments and determine the
fair value of other investments themselves? If so, what types of
investments would boards most likely assign to an adviser and under
what circumstances, and which would they fair value themselves? Should
we provide any additional guidance as to how boards would determine the
fair value of fund investments where the board does not assign those
determinations to an adviser?
2. Board Reporting
    Effective information flow is a critical part of a board's
oversight of an adviser to whom it has assigned fair value
determinations. We understand that boards currently receive a variety
of reports from the adviser outlining the operation of the fund's
valuation process.\97\ While some of the reports currently provided may
be useful for boards, others may contain detailed trade-by-trade
information, or other day-to day operational data that may not be
effective in facilitating the board's oversight. We believe that it is
important for the board to receive relevant and tailored information
from the adviser to ensure that the board has sufficient insight and
data to exercise the oversight contemplated by the proposed rule. We
also believe that these reports should familiarize directors with the
salient features of the adviser's process and provide them with an
understanding of how that process addresses the requirements of rule
2a-5. Therefore we are proposing the board reporting requirements
discussed below.\98\ These requirements are intended to help ensure
that boards receive the amount and type of information that they find
most valuable in overseeing the adviser.\99\
---------------------------------------------------------------------------

    \97\ See ``Practical Guidance for Fund Directors on Valuation
Oversight,'' Report of the Mutual Fund Directors Forum (June 2012)
(available at https://mfdf.org/images/Newsroom/Valuation-web.pdf)
(``MFDF Valuation Report'') at 14-15.
    \98\ This would be in addition to any reports required under
rule 38a-1. See Compliance Rules Adopting Release, supra footnote
26, at section II.A.2.c.
    \99\ The requirements we propose in this document would be
minimum requirements and fund boards could always ask for additional
reporting from advisers. See infra footnote 110 and accompanying
text.
---------------------------------------------------------------------------

    The proposed rule would require the adviser's reports to include
such information as may be reasonably necessary for the board to
evaluate the matters covered in the reports.\100\ This requirement is
designed to provide the fund's board with sufficient context for the
matters covered in the report. This context is necessary in order to
facilitate the board's oversight by providing them with enough
information to determine whether to ask additional questions or request
additional information, as appropriate. For example, we do not believe
that it would be consistent with the proposed rule for the adviser to
report that there is a new material conflict of interest without the
context necessary for the board to evaluate what effect the conflict
would have on the adequacy and effectiveness of the adviser's process
for determining fair value. The content of the periodic or prompt
reports and supplemental information under the proposal could take the
form of narrative summaries,

graphical representations, statistical analyses, dashboards, or
exceptions-based reporting, among other methods.
---------------------------------------------------------------------------

    \100\ Proposed rule 2a-5(b)(1). This is similar to the approach
we have adopted with regard to money market stress testing and
proposed with regard to board oversight of derivatives risk
managers. See 2014 Money Market Fund Release, supra footnote 14, and
Derivatives Release, supra footnote 17.
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a. Periodic Reporting
    Proposed rule 2a-5 would require the adviser, at least quarterly,
to provide the board a written assessment of the adequacy and
effectiveness of the adviser's process for determining the fair value
of the assigned portfolio of investments.\101\ We understand that the
materials currently prepared for boards for purposes of board meetings
can include detailed information regarding the fair value process,
including a list of each individual portfolio holding that received a
fair value since the prior board meeting (e.g., during the
quarter).\102\ Although some boards may find this specific information
useful, we are not proposing to mandate this level of detailed
reporting because we believe that the board's oversight may be better
facilitated through the use of more targeted forms of reporting
designed to identify trends, exceptions, or outliers, and generally
provide a sufficient overview of the current state of the fair value
process.\103\ Accordingly, the proposed rule would require the
adviser's periodic reports to provide the adviser's evaluation of the
adequacy and effectiveness of its process for determining fair value.
The periodic reports would be required to, at a minimum, include a
summary or description of the following information:
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    \101\ Proposed rule 2a-5(b)(1)(i).
    \102\ See MFDF Valuation Report, supra footnote 97, at 14.
    \103\ Fund boards could always request additional information if
they so choose. Proposed rule 2a-5(b)(1)(i)(F).
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     Material Valuation Risks. The assessment and management of
material valuation risks that would be required under the proposed
rule. This would include any material conflicts of interest of the
investment adviser and any other service provider.\104\ As discussed
above, we believe that assessing and managing identified valuation
risks is an important element for determining fair value in good faith
because valuation risks that are not effectively managed can make it
more likely that the adviser has incorrectly valued an investment.
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    \104\ Proposed rule 2a-5(b)(1)(i)(A). See supra section II.A.1
discussing this process. For example, the adviser could discuss
instances where it challenged the pricing information provided by an
affiliated or third party vendor.
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     Material Changes to or Material Deviations from
Methodologies. Any material changes to, or material deviations from,
the fair value methodologies established under the proposed rule.\105\
This requirement would keep boards informed of such changes or
deviations, which may show that the methodologies need to be updated or
adjusted, and provide an opportunity for a board to ask questions
regarding the reasons for any change or deviation.
---------------------------------------------------------------------------

    \105\ Proposed rule 2a-5(b)(1)(i)(B). For example, a report
could discuss when key inputs or assumptions are changed and the
reasons for the changes. We believe that both a material change and
the reason for it would be information that may be reasonably
necessary for the board to evaluate such changes.
---------------------------------------------------------------------------

     Testing Results. The results of any testing of fair value
methodologies as part of the required fair value policies and
procedures.\106\ As discussed above, the requirement to test the
appropriateness and accuracy of the methodologies used to calculate
fair value is designed to help ensure that the selected fair value
methodologies are appropriate and that adjustments to the methodologies
are made where necessary.
---------------------------------------------------------------------------

    \106\ Proposed rule 2a-5(b)(1)(i)(C).
---------------------------------------------------------------------------

     Resources. 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.\107\ The
adviser's assessment of the adequacy of these resources may inform a
board in determining the level of scrutiny to apply in overseeing an
adviser's fair value determinations.
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    \107\ Proposed rule 2a-5(b)(1)(i)(D). For example, an adviser
should disclose to the board when the adviser seeks to hire a new
pricing service to cover a new asset type or when replacing a person
with a background in valuation with a person without that background
in a position of authority regarding the adviser's fair value
process. See also proposed rule 2a-5(b)(2).
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     Pricing Services. Any material changes to the adviser's
process for overseeing pricing services,\108\ as well as any material
events related to its oversight of such services, such as changes of
service providers used or price overrides.\109\ This information is
designed to help the board oversee the adviser's use of pricing
services, if applicable, and to help ensure that pricing information
received from service providers serves as a reliable input for
determining fair value in good faith.
---------------------------------------------------------------------------

    \108\ If the board assigns the fair value determination to an
adviser under the proposed rule, the board would generally be aware
of an adviser initially appointing, and the establishment of the
process for overseeing, a pricing service as part of its oversight
and approval of the adviser's policies and procedures under rule
38a-1. As a result, we are not specifically proposing to require
that information be included in these periodic reports.
    \109\ Proposed rule 2a-5(b)(1)(i)(E). There may be times when
pricing information from a pricing vendor differs materially from
the adviser's view of the then-current fair value of the portfolio
holding, and the adviser may seek to contact the pricing vendor to
question the basis for the pricing information. Because this
difference in pricing suggests that further inquiry is needed to
assess the adequacy of the fair value process when these conflicts
occur, we are proposing to require this reporting.
---------------------------------------------------------------------------

     Other Requested Information. Any other materials requested
by the board related to the adviser's process for determining the fair
value of fund investments.\110\
---------------------------------------------------------------------------

    \110\ Proposed rule 2a-5(b)(1)(i)(F).
---------------------------------------------------------------------------

    These requirements collectively are designed to help ensure that
boards obtain the information that they need to exercise their
statutory and fiduciary duties and to oversee an adviser. They are
intended to supplement, not replace, this oversight. Boards should
critically review the information provided to them, particularly with
regard to an adviser's reporting on its own conflicts of interest, and
request any information that they feel is necessary to conduct that
oversight. For example, in addition to the specific items listed
above,\111\ a board could review and consider, if relevant:
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    \111\ Boards and fund CCOs may also consider requesting or
including items such as the examples given in the bullet list below,
if relevant, as part of the CCO's annual reports to the board under
rule 38a-1(a)(4)(iii).
---------------------------------------------------------------------------

     Summaries of adviser price challenges to pricing
information provided by third-party vendors and of price overrides,
including back-testing results related to the use of price challenges
and overrides;
     Specific calibration and back-testing data, including in
the case of back-testing whether fair value prices moved in the same
direction (relative to the prior market prices) as the portfolio
holdings' next actual market prices, whether fair value prices were
closer to the portfolio holdings' next actual market prices than the
prior market prices (regardless of the direction), and whether the
difference between the fair value prices and the subsequent prices was
greater than pre-established tolerance levels; \112\
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    \112\ See supra footnote 57. In these cases, reports on back-
testing could indicate whether fair value is being compared to
actual sales prices or to pricing information from pricing services
and dealers. In the latter case, the reports could state whether
dealer prices are actual bids or firm commitments or are indicative
or accommodation quotes that merely represent the opinion of the
dealer.
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     Reports regarding portfolio holdings for which there has
been no change in price or for which investments have been held at cost
for an extended period of time (``stale prices'');
     Reports regarding portfolio holdings whose price has
changed outside of

predetermined ranges over a set period of time;
     Narrative summaries or reports on pricing errors,
including the date of any error, the cause, the impact on the fund's
NAV, and any remedial actions taken in response to the error;
     Reports on the adviser's due diligence of pricing services
used by the fund;
     The results of testing by the fund's independent auditor
provided to the audit committee;
     Reports analyzing trends in the number of the fund's
portfolio holdings that received a fair value, as well as the percent
of the fund's assets that received a fair value; and
     Reports on the number and materiality of securities whose
fair values were determined based on information provided by broker-
dealers; the broker-dealers most frequently used for this purpose; and
the results of back-testing on the information they provided.
    We request comment on our proposed requirement that advisers
periodically provide a written evaluation of the adequacy and
effectiveness of the adviser's process for determining the fair value
of the assigned portfolio of investments, including, at a minimum,
certain specified summaries or descriptions.
    28. Is the proposed periodic reporting requirement appropriate?
What resources would be required for an adviser to provide the required
quarterly assessment of the adequacy and effectiveness of the adviser's
process? Are there additional or different matters that we should
require advisers to address in the periodic reports? Are there some
items that we should not require? If so, which, and why?
    29. Should we require a different minimum reporting frequency for
periodic reports? Should we, for example, require advisers to provide
these reports monthly or in connection with each regularly scheduled
board meeting? Should we require some or all of the specified
information to be provided less frequently, such as annually?
    30. Is what should be included in an assessment clear? Should we
include additional guidance to explain what this entails? Are the other
key terms used in the proposal, such as ``assess,'' and ``material''
sufficiently understood or is further guidance advisable for those
terms? Should they be defined in the rule, and, if so, how? Should the
rule use different terms, and, if so, which terms?
    31. Are there circumstances in which boards should receive specific
information on each individual portfolio holding that received a fair
value during the quarter or certain such holdings?
    32. We are proposing to require that all price overrides be
reported as supplemental information to the board as part of the
periodic report. Should we limit which price overrides must be
reported, and, if so, how? Alternatively or in addition, should we
require reporting regarding all price challenges, even those that do
not lead to overrides?
    33. Is there additional specific information that we should require
to be part of these periodic reports? Are there any other reports that
some boards currently receive that should be required under the
proposed rule?
    34. In light of their importance, should the rule impose specific
requirements beyond reporting regarding pricing services? For example,
should any pricing services used be explicitly approved by the board?
Should there be a required finding or report by the adviser as to
pricing services' adequacy and effectiveness?
b. Prompt Board Reporting
    We also believe that it is important for the adviser to notify the
board of certain issues as they arise that may require their immediate
attention. Proposed rule 2a-5 would require that the adviser promptly
report to the board in writing on matters associated with the adviser's
process that materially affect, or could have materially affected, the
fair value of the assigned portfolio of investments, including a
significant deficiency or a material weakness in the design or
implementation of the adviser's fair value determination process or
material changes \113\ in the fund's valuation risks.\114\ These
reports, like the periodic reports discussed above, also must include
such information as may be reasonably necessary for the board to
evaluate the matter covered in the report.
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    \113\ For example, a significant increase in price challenges or
overrides likely would reflect a material change to the fund's
valuation risks that should be promptly reported to the board,
    \114\ Proposed rule 2a-5(b)(1)(ii).
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    ``Could have materially affected'' is intended to capture certain
circumstances where, for example, a matter was detected which affected
one security and which may not be material on its own, but, had the
matter not been identified, could have materially affected the larger
assigned portfolio of investments or some subset of that
portfolio.\115\ This concept is not intended to mandate reporting in
circumstances where, at the time the matter was detected, it did not
seem that the matter would materially affect the fair value of the
assigned portfolio but the matter later ended up having such an effect.
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    \115\ See PCAOB AS 2201 An Audit of Internal Control Over
Financial Reporting That is Integrated with An Audit of Financial
Statements, Appendix A--Definitions .A7 (defining ``material
weakness'' and ``reasonable possibility''). See also Sarbanes-Oxley
Act, supra footnote 21, at Title III Sec. 302(a)(5).
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    We are proposing to require the adviser to provide these reports
promptly, but in no event later than three business days after the
adviser becomes aware of the matter, rather than waiting until the next
periodic report.\116\ We believe it is appropriate that the board
receive prompt reports regarding matters that materially affect fair
value determinations because the proposed rule would allow the board to
assign to an adviser fair value determinations otherwise allocated to
the board under the Act, and there may arise an issue of such
importance that requires prompt board attention. We recognize that the
kind of matters that may require this prompt reporting (i.e., outside
of the periodic reports) may vary. Some situations may warrant an
immediate report, while in other cases it may be appropriate for the
adviser to take some additional time to evaluate how to address the
matter before engaging the board. We believe that requiring such a
report to be ``prompt,'' but in no event later than three business days
after the adviser becomes aware, balances the need for the board to be
timely informed of material valuation issues, while allowing the
adviser to evaluate and respond appropriately.
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    \116\ Id.
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    We also understand, however, that there may be some circumstances
when an adviser becomes aware of an issue that may affect fair value of
the portfolio but that the materiality of a given event may be in
question. In such a case, an adviser may need additional time to
determine and verify whether an event has or could materially affect
the fair value of the portfolio assigned to the adviser. Accordingly,
we believe that if an adviser needs some reasonable amount of time
after becoming aware of the matter to verify and determine its
materiality, that verification period would not be counted as part of
the ``prompt'' trigger period. In general, we believe that this
verification and final determination process should be completed within
three business days or less, including the day that the adviser became
aware of the triggering event. Therefore, any prompt reports generally
should occur no more than three business days after the adviser becomes

aware of the event, but the adviser may, to the extent necessary, take
limited additional time (but in no event more than three business days)
for the verification and final determination process.
    We request comment on our proposed requirement regarding prompt
reporting on certain matters associated with the adviser's process that
materially affect, or could have materially affected, the fair value of
the assigned portfolio of fund's investments.
    35. Are the proposed prompt reporting requirements appropriate? Are
there additional or different matters that we should require advisers
to address in their prompt reports?
    36. Should the trigger for prompt reporting be tied to a specific
bright line or instead be dependent on facts and circumstances? For
example, instead of the trigger being when the adviser becomes aware of
the matter should it instead be when the event occurs? If so, would
advisers reasonably be able to know when such events occur such that
they could report in a timely fashion? Alternatively, should it be when
the adviser determines and verifies the impact of the event regardless
of how long it takes after the adviser becomes aware of the matter?
    37. Are the standards of ``materially affecting'' or ``could have
materially affected'' sufficiently understood? Should we provide more
context on what these terms mean, specifically as they relate to the
context of material weaknesses? Should we instead adopt a different
standard, such as one that uses specific triggers, to identify matters
for prompt reporting? If so, which triggers? For example, should we
instead require reporting when a specific number of price overrides
have occurred?
    38. Should we identify any other issues that the adviser should
report promptly to the board? For example, instead of requiring any
changes to the fund's fair value methodologies to be reported during
the periodic reports, should we instead require that they also be
reported promptly? Alternatively, are there matters that would be
required to be reported promptly that should instead be reported as
part of the periodic report?
    39. Is the specified timeline for prompt reporting appropriate or
should we consider different time frames? For example, should we
require that an adviser report to the board within 1 or 10 business
days? Should the time frame be different for certain types of
circumstances? If so, which ones?
    40. Will advisers be able to make the appropriate determinations in
the limited time discussed above? Will advisers need more than three
business days to make such a materiality decision? Is three days too
long? Should we specify a time for making materiality decision in the
rule?
    41. The proposed rule would require all reports to be in writing,
including prompt reports. Should we provide that in the case of prompt
reports, advisers could make oral reports so long as adequate records
are kept?
    42. Should we require that, if the report is not made to the full
board, the designated board committee make a report to the full board
within a specified time frame, such as at the next regularly scheduled
meeting?
    43. Should we permit the adviser to make prompt reports to a pre-
identified individual director? What controls should we require if we
did permit this? For example, should that director be required to be
one of the independent directors?
3. Specification of Functions
    If the board assigns the fair value determination requirements for
one or more fund investments to an adviser, the proposed rule would
require the adviser to specify the titles of the persons responsible
for determining the fair value of the assigned investments, including
by specifying the particular functions for which the persons identified
are responsible.\117\ If the adviser uses a valuation committee or
similar body to assist in the process of determining fair value, the
fair value policies and procedures generally should describe the
composition and role of the committee, or reference any related
committee governance documents as appropriate. In addition, the fair
value policies and procedures also should identify the specific
personnel with duties associated with price challenges, including those
with the authority to override a price, and the roles and
responsibilities of such persons, and establish a process for the
review of price overrides.\118\
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    \117\ Proposed rule 2a-5(b)(2).
    \118\ See also proposed rule 2a-5(a)(4).
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    In addition, the proposed rule would require the adviser to
reasonably segregate the process of making fair value determinations
from the portfolio management of the fund.\119\ One significant source
of potential adviser conflicts of interest in the fair value
determination process is the level and kinds of input that fund
portfolio managers or persons in related functions have in the design
or modification of fair value methodologies, or in the calculation of
specific fair values.\120\ In many circumstances, the fund's portfolio
manager may be the most knowledgeable person at an investment adviser
regarding a fund's portfolio holdings. For this reason, it may be
appropriate for portfolio managers to provide input into the process
for determining the fair value of fund investments. On the other hand,
because portfolio management personnel are often compensated in part
based on the returns of the fund, a portfolio manager's incentives may
not be fully aligned with the fund's with respect to determination of
fair value, and a portfolio manager therefore should not be making the
fair value determinations.\121\
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    \119\ See In re Morgan Asset Management, supra footnote 9.
    \120\ Id. at 4 (fund's portfolio manager ``actively screened and
influenced a broker-dealer to change the price confirmations [and]
failed to advise . . . when he received information indicating that
the Fund's prices for certain securities should be reduced.'').
    \121\ In addition, as the person most directly responsible for
the fund's investments, the portfolio manager may also be concerned
about the reputational or career implications of the fund's
performance, or its compliance with investment limitations, which
can provide an incentive to smooth returns or otherwise misvalue
portfolio holdings.
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    Further, we believe that a fund generally should consider the
extent of influence portfolio managers may have on administration of
the fair value process, and seek to provide independent voices and
administration of the process as a check on any potential conflicts of
interest to the extent appropriate.\122\ Separation of functions
facilitates these important checks and balances, and funds could
institute this proposed requirement through a variety of methods, such
as independent reporting chains, oversight arrangements, or separate
monitoring systems and personnel. The proposed rule would require
reasonable segregation of functions, rather than taking a more
prescriptive approach, such as requiring funds to implement strict
protocols regarding communications between specific personnel, to allow
funds to structure their fair value determination process and portfolio
management functions in ways that are tailored to each fund's facts and
circumstances, including the size and resources of the fund's adviser.
In this regard, the reasonable segregation requirement is not meant to
indicate that portfolio management must necessarily be subject to a
communications ``firewall.'' We recognize the important perspective and
insight regarding the value of fund holdings that portfolio management

personnel can provide. Accordingly, this segregation requirement would
not prevent portfolio managers from providing inputs that are used in
the fair value determination process, as noted above. Instead, this
reasonable segregation requirement is designed to help reduce and
manage potential conflicts of interest. Keeping the functions
reasonably segregated in the context of fair value determinations
should help mitigate the possibility that these competing incentives
diminish the effectiveness of fair value determinations.
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    \122\ See Liquidity Risk Management Release, supra footnote 3,
at section III.H.1.
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    We request comment on this proposed requirement.