SEC Promulgates Rule 2a-5: Get The Highlights On Coming Changes

Are you ready for the new SEC modernization rules for fund valuation practices? Find out here how rule 2a-5 might affect you.

Last year, the Securities and Exchange Commission proposed Rule 2a-5 under the Investment Company Act of 1940. Rule 2a-5 was meant as an update to valuation practices pertaining to the fair value of investments held by funds covered by the Act.

On December 3, 2020, the SEC announced that it had officially adopted the new and (hopefully) improved Rule 2a-5. We’re told that this is the first time in more than half a century that the SEC has comprehensively tackled valuation rules for the investments held by registered investment companies — better late than never, I suppose. But what is actually changing, and what does it mean, in plain English, for the people dealing with the revamped guidelines?

The Investment Company Act of 1940 has always required funds, when market quotations are “readily available,” to use the market value of portfolio securities to value their portfolio investments. When market valuations are not “readily available,” however, the Act requires that portfolio investments be valued using the security’s fair value. Not a lot of guidance was previously available on what “fair value” actually meant though, or on how to get there, other than that the fund’s board had to determine the fair value in good faith.

Rule 2a-5 still allows the board to determine fair value in good faith, but in the alternative, it now allows a valuation designee to come to a fair valuation. For most funds, the board does not have a day-to-day role in pricing fund investments, and the new rule recognizes this reality (although a board’s oversight of any valuation designee must be active).

True leadership is sometimes recognizing one’s own shortcomings, and for most boards, turning to a qualified valuation designee is likely to make their jobs easier while simultaneously arriving at better good faith approximations of fair value. For internally managed funds, an officer of the fund is an SEC-approved choice for valuation designee. A fund’s investment adviser is a generally applicable option for valuation designee. For a unit investment trust, which does not have a board of directors or investment adviser, the UIT’s trustee or depositor would be responsible for making a fair value determination under the new rule.

In addition to allowing the board to delegate a bit more, the new Rule 2a-5 specifies certain functions which must be periodically performed in assessing the fair value of a fund’s investments in good faith. These include:

  • assessing and managing material risks associated with fair value determinations;
  • selecting, applying and testing fair value methodologies; and
  • overseeing and evaluating any pricing services used (third parties who supply funds with price opinions, evaluated prices, matrix prices, or similar pricing estimates or information).

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Highlighting potential sources of valuation risk is an area of particular focus for the new Rule 2a-5. Valuation risk associated with the particular type of investments held is a more obvious one, as are possible market or sector shocks or dislocations. Less obvious sources of valuation risk, perhaps, are things like the extent to which a fair valuation methodology uses actually observable inputs (especially if those inputs are provided by the adviser), or the use of fair value methodologies that rely on inputs from third parties and the extent to which those third parties rely on service providers of their own — what is referred to more colloquially as “fourth party” risks. This is only a small taste of the potential sources of valuation risk laid out in Rule 2a-5, which gets far more granular than previous iterations of the applicable guidance.

There is a lot more to Rule 2a-5, and eventually, you are probably going to have to read Rule 2a-5 in all its resplendent, redundant, unnecessarily wordy glory. You have some time though. The final version of the Rule became effective on March 8, 2021, 60 days after its publication in the Federal Register. But, thankfully Rule 2a-5 has a compliance date 18 months after the effective date, for the avowed purpose of giving folks like you time to familiarize yourselves with it.

So, if you haven’t already, start thinking about whether Rule 2a-5 applies to your organization, whether the board members would like to shed some responsibility in favor of someone more qualified (hint: they would), and whether you need to lie awake at night dreading the many new types of risk you probably already knew about but weren’t previously constantly reminded of (really, get your sleep though, the risks will still be there in the morning). Marcus Aurelius reminded us, “The universe loves nothing so much as to change the things which are.” Hopefully this change, growing pains aside, ultimately ends up for the better.


Jonathan Wolf is a civil litigator and author of Your Debt-Free JD (affiliate link). He has taught legal writing, written for a wide variety of publications, and made it both his business and his pleasure to be financially and scientifically literate. Any views he expresses are probably pure gold, but are nonetheless solely his own and should not be attributed to any organization with which he is affiliated. He wouldn’t want to share the credit anyway. He can be reached at jon_wolf@hotmail.com.

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