How well do you know your mutual fund pricing provider?
That was the important question posed by the Securities and Exchange Commission in a nearly 900-page release in 2014 ostensibly focused on other matters, as indicated by the pithy title: “Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166, July 23, 2014.”
Buried on pages 285-288, the Commission declared that:
“… we believe it is important to provide guidance to funds and their boards regarding reliance on pricing services.”
Some of the content in the money market reforms came as a surprise to many mutual fund directors and officers.
Cat Amongst Pigeons
While recognizing that the use of pricing services by mutual funds is both a widespread and acceptable method of helping funds to ‘fair value in good faith’ assets where ‘market prices are not readily available,’ the SEC reiterated much of its guidance from ASR 113 (1969) and ASR 118 (1970) stating that evaluated prices are not by themselves either readily available market prices or fair values as required under the ’40 Act. The Commission reminded boards of directors that they had a non-delegable responsibility to determine whether prices provided by these services (or, for that matter, any other source) constituted fair value.
Additionally, the money market release restated that it is incumbent upon fund boards to satisfy themselves that all factors relevant to the determination of fair valuation of securities had been considered and that the methods used to do so must be continuously reviewed.
So much of this we all knew already—or should have known—since such advice has been around since 1969. It was the subsequent comments on the duties of the board of directors in relation to pricing services that really put a cat amongst the pigeons.
First of all, the release noted:
“We recognize that pricing services employ a wide variety of pricing methodologies in arriving at the evaluated prices they provide, and the quality of those prices may vary widely.”
Therefore, before using such services to help it value fund securities, the board of directors:
“…may want to consider the inputs, methods, models, and assumptions used by the pricing service to determine its evaluated prices, and how those inputs, methods, models, and assumptions are affected (if at all) as market conditions change.”
Did the Commission really intend this to be optional?
Furthermore, in addition to the “quality” of the data provided by external pricing services as defined by the factors above, the guidance stated that a board “may want to assess” (optional again?) the time that these prices are produced in relation to the time the fund calculates its net asset value. It also cautions that the appropriateness of the evaluations from pricing services should be considered specific to the fund’s circumstances, and that they should not be used if the board did not believe that these values reflected what the fund could reasonably expect to obtain in a current sale under current market conditions.
One immediate interpretation of these statements that caused a ripple of panic amongst fund boards was that the directors themselves needed to be experts in fair valuation techniques rather than relying on their appointees at the investment adviser, on the valuation committee, or at a third party. Given the typical makeup of many mutual fund boards, this seemed a pretty tall order.
Review Policies, Procedures
So what was the Commission’s intention in publishing this guidance? Why did the regulator believe it was important?
Norm Champ, former director of the SEC’s Division of Investment Management and a key architect of the money market reforms, said recently that the Commission was surprised by the industry reaction to this guidance. The SEC did not feel that the reforms said anything new about valuation, Champ said. Boards always have had a non-delegable responsibility for fair value, and while they are able to appoint others to help them with this duty, they ultimately must satisfy themselves that it is being done properly and fairly.
Equally, there is no panacea for this. As Champ himself said on one occasion:
“There is no single methodology for determining the fair value of a security or other asset because fair value depends upon the facts and circumstances of each situation.”
Additionally, this process must not be a set-and-forget exercise. The board must review its valuation policies and procedures regularly to ensure they remain appropriate. Failure to do so always has been punished, and there have been a series of enforcement actions throughout the years demonstrating the Commission’s resolve in this respect.
However, the detailed guidance on the use of pricing services, and what factors the board should be considering with regard to due diligence of these vendors, was undoubtedly new. While recognizing the use of pricing services in previous guidance, the Commission had never before given such detailed recommendations on the specific factors that fund directors “may want to consider” in overseeing the use of such companies.
The details on the board’s requirement to assess how these factors might be impacted under changing market conditions was also new. This provided additional evidence of the latest staff thinking on valuation issues and foreshadowed the fund stress testing ideas subsequently floated for 2016. This type of scenario analysis is already in place for banks, and even though asset managers appear to have avoided being classified as systematically important financial institutions (SIFIs), there is a clear intent to ensure that funds are aware of how market moves can impact them.
One does not have to look hard to see what prompted the SEC to reiterate the fund board’s duties with regard to pricing. The Morgan Keegan enforcement occurred in 2011 for the adviser and some of its staff, but in 2013 the fund directors also were sanctioned (J. Kenneth Alderman et al., Investment Company Act Release No. 30557 (June 13, 2013) (settlement)).
As the administrative proceeding brutally stated:
“The Directors did not specify a fair valuation methodology pursuant to which the securities were to be fair valued. Nor did they continuously review how each issue of security in the Funds’ portfolios were being valued. The Directors delegated their responsibility to determine fair value to the Valuation Committee of the investment adviser to the Funds, but did not provide any meaningful substantive guidance on how those determinations should be made. In addition, they did not learn how fair values were actually being determined. They received only limited information on the factors considered in making fair value determinations and almost no information explaining why fair values were assigned to specific portfolio securities. These failures were particularly significant given that fair valued securities made up the majority—and in most cases upwards of 60%—of the Funds’ net asset values (“NAVs”) during the Relevant Period.”
That’s pretty damning stuff.
The explicit reference in the 2014 guidance to the timing of evaluated pricing snaps also reflects the lessons learned from the market timing problems at the turn of the century. The fair valuation of international equity prices seems to have headed off much of the fund arbitrage possible in this context, but of course, now we have junk bond exchange-traded funds.
The ignominious story of the Third Avenue Focused Credit Fund also acts as a suitably salutary recent lesson on the need to consider how market conditions might impact valuations.
Understanding the Methodologies
The conclusions that can be drawn from all this seem quite clear. The SEC seems to expect boards to be more involved than ever in the valuation process—and more knowledgeable than ever about how it works (regardless of whether valuation is done internally or by a vendor).
Regardless of whether the fund board appoints the adviser or a valuation committee to perform the fair value task, it is incumbent on the board both to understand and oversee the process in a meaningful fashion. Fair valuation responsibility is non-delegable, so whilst the day-to-day work can be outsourced, the responsibility cannot.
In the event that a pricing service is used to assist in this duty, this oversight requirement applies equally to them. The directors should apprise themselves of the pricing service methodology and processes and satisfy themselves that these are and remain appropriate—not just generally, but for the specific circumstances of the fund and the securities it holds.
It is therefore not sufficient for a board or its appointees merely to review a generic methodology document from a pricing service and make do with some ticked boxes on a questionnaire. The continued appropriateness of the pricing service as an aid to fair valuation must be assessed in relation to the fund’s specific holdings and circumstances.
The board also is required to understand how these pricing methods might react under different market circumstances and keep this under “continuous review” (for instance, whether critical inputs and assumptions used by pricing services are sound enough to survive stressed market conditions).
There was a recent example of this when more than half of the Chinese shares on the Shenzhen stock exchange were suspended from trading and required fair valuation. Holders were left scrambling for a Plan B when trade prices dried up. Indeed, emerging markets in both debt and equity provide the most fertile area for such troubles in the foreseeable future.
Finally, set-and-forget is not an option here. “Because we always did it that way” is not an excuse that is going to receive much shrift from the Office of Compliance Inspections and Examinations or the Division of Enforcement. Fund boards should ignore this at their peril.
Ian Blance is managing director of Voltaire Advisors LLP, a specialist advisory firm focused on pricing and valuation issues faced by asset managers and their servicers.
 Ibid, p.286
 Ibid, p.286
 Ibid, p.286
 Ibid, p.286
 Ibid, p.287
 Ibid, p.287
 Ibid, p.2