Viewpoints

Op-Ed: Whither valuation guidance?

December 6, 2019

By Douglas Scheidt

The Securities and Exchange Commission should issue valuation guidance for investment companies. When I was chief counsel in the SEC's Division of Investment Management from 1997 to 2018, I frequently advocated for the SEC to issue valuation guidance. Although the SEC has indicated a willingness to do so on several occasions during the past 20 years, the SEC generally has avoided the topic, except for money market funds[1] and in the occasional enforcement action.

 

Now is the time to change all of that.

 

What issues should the SEC address in its valuation guidance? There are many possibilities. I can suggest a few:

 

  • The SEC should consider issuing comprehensive valuation guidance. The last time that the SEC issued comprehensive valuation guidance was almost 50 years ago.[2] So much has changed in the fund industry since then: the markets; many new, complex and difficult-to-value instruments; heavy reliance on pricing services; and emerging technologies that permit enhanced price discovery and greater valuation transparency. While FASB's valuation guidance has been helpful, it does not address many issues that are unique to funds. Pity the fund directors, who are tasked with sorting this all out, ever-concerned that the SEC's examination office and its Enforcement Division will second-guess their efforts. Wouldn't it be far preferable for the SEC to issue comprehensive valuation guidance in an interpretive release, after notice and opportunity for public comment, rather than to address individual valuation issues in exams and enforcement actions? The SEC should issue comprehensive valuation guidance.

 

  • The SEC should consider issuing guidance on the critical role that fund directors play in the valuation process. Fund directors have a statutory mandate to make fair valuation determinations. In 1970, the SEC issued interpretive guidance that made it more practical for fund boards to make fair valuation determinations by permitting them to appoint the fund's investment adviser to make the actual fair value calculations by applying board-approved fair valuation methodologies, provided that the board regularly reviews those calculations and the continuing appropriateness of the fair valuation methodologies.[3] This guidance has been reiterated in several SEC enforcement actions.[4] The SEC should re-affirm this guidance, and modify or supplement it as may be necessary in light of developments and practices that have occurred over the past 50 years.

 

  • The SEC should consider issuing valuation guidance concerning whether fund directors must ratify any pricing determination made by the fund's investment adviser (or a valuation committee) when either (a) the directors hadn’t previously authorized the use of a fair valuation methodology for that portfolio security or (b) the adviser (or committee) used a fair valuation methodology that was different from the methodology that the directors had previously approved. Oftentimes, a fund's investment adviser or valuation committee will determine that a fund portfolio security should be fair valued, but either (a) the fund’s board may not have previously approved the use of a particular fair valuation methodology for that security, or (b) the adviser or the committee may believe that a methodology previously approved by the directors is no longer appropriate to use. In either case, there may not be time for the adviser or committee to seek the board's approval of a new approach before the fund's 4 p.m. net asset value (NAV) calculation, but the adviser or committee will nevertheless use that new approach so that the fund's NAV more accurately reflects current market conditions. Under these circumstances, many fund boards will review and ratify the adviser's or committee’s valuation determinations at the fund’s next board meeting. Other fund boards and their counsel argue that board ratification is not required under these circumstances. The SEC should issue guidance clarifying whether board ratification is required when the fund’s investment adviser or valuation committee applies a fair valuation methodology that has not previously been authorized by the fund's board.

 

  • The SEC should not issue guidance or exemptive relief permitting fund directors to delegate their statutory fair valuation responsibilities to fund advisers or other third parties. The Investment Company Act places on the fund's directors the responsibility of determining the fair value of the fund's portfolio securities. The Act did so, not because the fund directors are experts in valuation, but because they serve as the only effective check on the fund's investment adviser, which has an incentive to inflate the value of the fund's portfolio securities in order to artificially boost the fund's performance or to attract new investments in the fund, both of which will inflate the adviser's compensation. Numerous enforcement actions demonstrate the abuses that can occur when fund advisers inflate the values of fund portfolio securities or when fund directors erroneously delegate their fair valuation responsibilities to the fund advisers.[5] Many fund boards have become quite adept at managing their fair valuation responsibilities. The "solution" is for more fund boards to also become adept at managing their fair valuation responsibilities, and not for the SEC to permit fund boards to delegate their fair valuation responsibilities to fund advisers or others. The SEC should not issue guidance or exemptive relief permitting fund directors to delegate their statutory fair valuation responsibilities to fund advisers or other third parties.

 

  • The SEC should consider issuing guidance concerning whether funds are required to fair value their exchange-traded securities when post-market close events occur that affect the values of those securities. The SEC issued guidance in 1984 indicating that funds are required to fair value their exchange-traded portfolio securities (particularly foreign securities) when the closing prices of those securities are stale.[6] The IM staff also issued valuation guidance concerning this issue in 2001.[7] The SEC should re-affirm its prior guidance, address the additional issues raised in the staff’s 2001 guidance, and modify or supplement the prior guidance as may be necessary to address fund valuation practices.

 

  • The SEC should consider issuing guidance concerning whether index-based funds, including index-based ETFs, are required to fair value their exchange-traded portfolio securities when the closing prices of those securities are stale. Some index funds and index-based ETFs argue that they should not be required to fair value their exchange-traded portfolio securities when the closing prices of those securities are stale. They assert that the use of fair values, rather than closing prices, would result in "tracking error," i.e., a divergence between the performance of the funds and the performance of the relevant index. In addition, some index-based ETFs that sell and redeem their shares only through in-kind transactions argue that their exclusive use of in-kind transactions for all purchases and redemptions of ETF shares eliminates the need to fair value their exchange-traded portfolio securities when the closing prices of those securities are stale. The SEC should issue guidance concerning whether index-based funds and ETFs are required to fair value their exchange-traded portfolio securities with stale closing prices when doing so would cause tracking error or when index-based ETFs exclusively use in-kind transactions for purchases and redemptions of their shares.

 

  • The SEC should consider issuing guidance concerning funds' valuation of derivatives. Some derivatives, such as exchange-traded futures and options, can generally be valued by using readily available market quotations. Such quotations, however, are not available for many other derivatives, and funds must use other methods to determine their fair value. The SEC has not previously provided guidance on funds' valuation of derivatives. The SEC should issue guidance concerning funds' valuation of derivatives.

 

  • The SEC should consider issuing guidance on the appropriateness, or not, of the use of the enterprise valuation methodology by BDCs. Many business development companies (BDCs) use the enterprise valuation methodology (EVM) to fair value their portfolio securities. EVM is based on the valuation of the entire portfolio company; BDCs determine the enterprise or "going concern" value of a portfolio company and then allocate that value to the outstanding capitalization of the company as of the valuation date, thereby deriving the portion of the enterprise value that is attributable to the portfolio securities owned by the BDCs. EVM often results in the valuation of debt securities at par, which appears to ignore interest rate fluctuations and risks faced by the portfolio company. The SEC has observed that funds should not ignore changes in interest rates when valuing debt securities,[8] and the SEC has filed an enforcement action against a BDC for using EVM to fair value debt securities issued by portfolio companies that the BDC did not control.[9] The SEC should issue guidance concerning whether, and if so under what circumstances, BDCs can use the enterprise valuation methodology to fair value their portfolio securities.

 

  • The SEC should consider issuing guidance on whether funds may use block discounts or premiums for large holdings of portfolio securities, and whether funds are required to fair value portfolio securities that are owned in "odd lots." Some funds have questioned whether a fund may value an unrestricted security at a "block discount" or "block premium" (i.e., a discount from the readily available market quotations for that security based solely on the large size of the fund’s holding relative to the average daily trading volume of the security, or a premium to the readily available market quotations for that security based solely on the large size of the fund's holding relative to the total number of the issuer's outstanding securities, respectively). Prior SEC guidance suggests that funds, when valuing their portfolio securities, should take into consideration the number of shares of portfolio securities that they own,[10] whereas FASB guidance would suggest otherwise. The SEC also has indicated in an enforcement action that funds are required to fair value portfolio securities that are owned in "odd lots."[11] The SEC should issue guidance concerning whether, and if so under what circumstances, funds may use block discounts or premiums to value large holdings of portfolio securities, and whether funds are required to fair value portfolio securities that are owned in "odd lots."

 

The SEC last issued comprehensive fair valuation guidance almost 50 years ago, and it hasn't addressed many valuation issues that funds and their directors grapple with every day. The SEC should issue comprehensive fair valuation guidance in an interpretive release, after notice and opportunity for comment, much like it did recently when it issued guidance on fiduciary duties applicable to investment advisers.[12] Alternatively, the SEC should issue fair valuation guidance on the other specific valuation issues noted above.    


Douglas Scheidt is an adjunct professor at Howard University School of Law and at the Raymond A. Mason School of Business at William & Mary and has worked as a consultant and expert witness on investment management regulatory matters since retiring from the Securities and Exchange Commission in September 2018. When he wrapped up his 32-year career at the SEC last year, Scheidt was associate director and chief counsel in the Division of Investment Management.


[1] Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (2/23/14).

[2] Securities and Exchange Commission Codification of Financial Reporting Policies, Accounting for Investment Securities by Registered Investment Companies, Investment Company Act Rel. No. 6295 (12/23/70) (“ASR 118”).

[3] Id.

[4] See, e.g., In the Matter of Jon D. Hammes, et al., Investment Company Act Rel. No. 26290 (12/11/03);  In the Matter of J. Kenneth Alderman, et al., Investment Company Act Rel. No. 30557 (6/13/13).

[5] See, e.g., In the Matter of Morgan Asset Management, Inc., Investment Advisers Act Rel. No. 3009 (4/7/10);  In the Matter of J. Kenneth Alderman, et al., Investment Company Act Rel. No. 30557 (6/13/13).

[6] Investment Company Act Rel. No. 14244, at n.7 (11/21/84).

[7] See Letter to Craig S. Tyle, General Counsel, Investment Company Institute, from Douglas Scheidt, Associate Director and Chief Counsel, Division of Investment Management (4/30/01).

[8] See Report of Investigation in The Matter of Greater Washington Investors, Inc., 1934 Act Rel. No. 15673 (3/22/79).

[9] See In the Matter of KCAP Financial, Inc., et al., 1934 Act Rel. No. 68307 (11/28/12).

[10] ASR 118.

[11] Pacific Investment Management Company LLC, Investment Advisers Act Rel. No. 4577 (Dec. 1, 2016)

[12] Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Rel. No. 5248 (6/5/19).

 

 

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