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Current Sale; Review and Delegation. Accounting Series Releases 113 and 118 addressed an issue that had developed during the “go-go” years of the 1960’s: the acquisition of restricted securities – known then as letter stock – in lieu of tradable issues of the same securities. ASR 113 noted that these securities were purchased at a discount and should not be immediately valued at the market price of unrestricted securities. It stated the proposition, oft since repeated, that “[a]s a general principle, the current fair value of restricted securities would appear to be the amount which the owner might reasonably expect to receive for them upon their current sale.” ASR 113 also concluded that determining a current sale price precluding simply adopting a standardized discount from the market price of registered stock, whether or not that discount was being amortized over a specified period. The release advised directors to “continuously review the appropriateness” of the method by which they instruct fund personnel to do the “actual calculations.” This guidance was repeated in ASR 118.

In addition, ASR 113 cautioned funds not to hold more than 10% of its net assets in” assets not having readily available market quotations” lest they be unable to cover redemption requests within seven days, as required by section 22(e) of the Act, or be forced to engineer redemptions in a way that causes dilution to the remaining shareholders, such as selling more liquid securities until only less liquid, more volatile ones are left in the portfolio. Liquidity issues remain of concern to this day and are addressed in the SEC’s September 2015 proposal to mandate “Open-End Fund Liquidity Risk Management Programs.4” As the SEC did, we will return to this issue – below.

Factor Analysis. ASR 118 added to the onus on the board in making fair value determinations, instructing directors to “satisfy themselves that all appropriate factors relevant to the value”

Valuation Issues for Registered Investment Company Directors – Recent Developments and Surprises By Ronald M. Feiman, Partner

Updated valuation guidance from the Securities and Exchange Commission was long awaited – and long promised – when, in the release adopting money market reform in July 20141, it was revealed that six or so pages of general guidance – not in the least specific to money market funds – had been dropped into the middle of the almost 900-page release.2

Background

As is well known, the previous official guidance from the SEC had been provided 44 years earlier, In the form of Accounting Series Releases issued in1969 and 1970, following the enunciation in 1968 of Rule 22c-1. That rule formally required that redeemable securities of registered funds be sold and redeemed only at “a price based on the current net asset value of such security which is next computed” after an order or redemption request. “Current net asset value” had been tied to the statutory definition of “value”3 by Rule 2a-4 in 1964 to establish uniformity in treatment by the industry.

Definitions and Framework. The Act, and the rules under it, reflect the intent of Congress favoring consistent externally-generated securities prices over self-determined prices. It defines “value” to mean the market value of securities “for which market quotations are readily available” and, for other securities “fair value as determined in good faith by the board of directors.”

Good Faith. The fund board appeared to be the best approximation that Congress found in 1940 for an external source of asset values in the absence of market prices, and boards were given latitude subject only to their good faith in determining their “fair value” prices.

of such securities “have been considered and to determine the method of arriving at” fair values.5 Then the release set forth a list of some general factors that “should” be considered. This is being the beginning of the process by which the Commission has demanded more than “good faith” on the part of directors.

In the adoption of Rule 2a-7 in 19836, permitting amortized cost or penny-rounding valuation methods for commercial paper and other money market securities, the Commission required boards to determine the adequacy of the method as “fairly reflecting the value of each shareholder’s interest” both “in good faith,” per the statutory phrase, and “based upon a full consideration of all material factors,” as stated in ASR 118. It further required the board to adopt “procedures” – “as a particular responsibility within the overall duty of care” – that are to be “reasonably designed” to stabilize the fund’s value and take action to reduce dilution when deviations occur.7 When Community Bankers’ U.S. Government Money Market Fund “broke the buck” in mid-1994, as a result of its holding of structured note derivatives, its board members, including three independent directors, were sanctioned (in a 1999 settlement)8.

Permission to Fair Value Despite Market Quotations. In 1980, the SEC staff was challenged by an issue arising from the increasing popularity of mutual fund investment in foreign securities, the exchanges for which closed hours before the close of the domestic markets and the time of pricing for U.S. funds. What would happen if there were a foreign closing market price but an event occurred before the NYSE close that presaged a significant divergence before the foreign market reopened - whether the news was company-specific, like a financial report or a merger proposal, or market-related, like a typhoon or the imposition of currency controls? In a no-action letter requested by Putnam,9the Staff of Voltaire

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1 Xxxxx2 The Federal Register version is only 249 pages in three columns each.3 Section 2(a) (41) (B) of the Investment Company Act of 1940 (the

“Act”), formerly numbered section 2(a) (39).

4 Open-End Fund Liquidity Risk Management Programs; Swing Pricing, Rel. Nos. 33-9922; IC-31835 (September 22, 2015) (the “Liquidity Proposal”).5 It also addressed market value determinations, allowing the use of bid prices for quoted securities or the mean of relevant quotations.6 Adoption of Requirements Regarding Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Rel. No. IC-13380 (July 11, 1983), following proposing release IC-12206 (February 1, 1982).

7 In rule amendments, the SEC subsequently added and then strengthened “risk limiting conditions” designed to avoid the likelihood that dilutive deviations could develop, but these conditions were more about reducing investment options to the safest of securities than about changing valuation methods.

8 They were found to have engaged in disclosure violations for knowingly misidentifying the level of illiquid holdings and the share price and abetting Rule 22c-1 violations by authorizing sales and redemptions at improperly valued share prices.

9 The Putnam Growth Fund and Putnam International Equities Fund, Inc., (pub. av. 2/23/81)

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the SEC permitted funds to use fair value for foreign securities when “an event has occurred … that is likely to have resulted in a change in such value,” despite the wording of Rule 2a-4. This position was adopted by the Commission in amendments to Rule 22c-1 in 1984.10

In 1999, the SEC Staff provided guidance11 on the phrase used in section 2(a) (41) that market quotations should be used if they are “readily available.” Rather than allowing a fund (or its board) to determine whether quotations are available, the Staff took a firm position that if a market “does not open for trading for an entire trading day, and no other market prices are available” then market quotations are not “readily available” and fair value procedures must be used. This Staff guidance included a more extensive list of factors than in ASR 118 intended to take into account the “development of world financial markets and the proliferation of new financial products.”

SEC Staff Prefers Fair Value Over Market Price. Although the 1999 letter required a full day’s exchange failure to invoke fair value conditions, by 2001, the Staff determined12, flipping the statute on its head, to prioritize fair value over market value if a “significant event” occurred after the close of a foreign market. A significant event is any circumstance (whether or not directly related to the specific security or foreign market, e.g., a change in general U.S. market prices) that “will affect the value of a portfolio security” after the foreign exchange has closed but before the fund’s next calculated net asset value. By asserting that the existence of any such circumstance made the closing market price no longer “readily available,” the Staff required that the board’s

10 [i]f an event does occur which will affect the value of portfolio securities after the market has closed, the fund must, to the best of its ability, determine the fair value

11 Letter to ICI Regarding Valuation Issues from Douglas Scheidt, Associate Director and Chief Counsel of the SEC Division of Investment Management (December 8, 1999).

12 Letter to ICI Regarding Valuation Issues from Douglas Scheidt, Associate Director and Chief Counsel of the SEC Division of Investment Management (April 30, 2001).

fair value process had to work full time, round the clock, rather than when trading in a security was restricted or not reported. This process assumes that a board of directors that meets perhaps as little as four times a year is the proper manager of such an ongoing operation.

Further Down a Slippery Slope. Following the mutual fund scandals that surfaced in 2003, including late trading and market timing of funds with the complaisance and even participation of fund management, the SEC successfully imposed a compliance programs on investment companies, designed to assure that the provisions of the federal securities acts would be obeyed, that had been proposed before the scandals arose. Because fund managers participated in improper activities it was natural that the Commission would require fund boards and independent directors in particular to oversee the new programs.

However, the Commission addressed violations of the fund pricing rule 22c-1 in part by reflexively adopting the Investment Management Staff guidance regarding fair valuation in its 2001 letter (without having raised in the proposing release the possibility of adopting this guidance). Rather than considering an alternative exemptive rule that would impose ongoing requirements directly on funds and their investment advisers, Rule 38a-1 accepted the Staff’s redefining and reprioritizing the 1940 Act’s definitions and imposed impractical ongoing responsibilities on boards. The adopting release stated:

funds that fail to fair value their portfolio securities under such circumstances may violate rule 22c-1 under the Investment Company Act. Fund directors who countenance such practices

fail to comply with their statutory valuation obligations and fail to fulfill their fiduciary obligation to protect fund shareholders. Accordingly, rule 38a-1 requires funds to adopt policies and procedures that require the fund to monitor for circumstances that may necessitate the use of fair value prices; establish criteria for determining when market quotations are no longer reliable for a particular portfolio security; provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security; and regularly review the appropriateness and accuracy of the method used in valuing securities.13

What the SEC did not focus on in adopting Rule 38a-1 was that the rule encourages hindsight bias on the part of the inspection and enforcement staffs. If a compliance failure occurs, it must have been obvious and significant (because in retrospect the chance of it arising seems like 100%). It also effectively imposes strict liability, since either the risk was not addressed in the funds policies or the procedures used were not reasonably designed to avoid the occurrence.

With respect to directors, however, and valuation issues in particular, the compliance rule changes the standard from the statutory one of mere “good faith” to the same strict liability imposed on day-to-day management. Whereas, in proceedings against the independent directors of the Heartland Group’s bond funds settled14 a week before the compliance rule was adopted, the SEC stated that the board had become aware of

the funds’ increasing illiquidity and mispricing of its securities and “should have known” that carrying prices of bonds did not reflect “fair value as determined in good faith,”15 later administrative proceedings took a different approach. In its settlement with the independent directors of the Morgan Keegan funds16, the order begins with the charge that the directors “did not specify a fair valuation methodology” (for the securitizations of subprime mortgages held by the funds), nor “continuously review how each issue … were [sic] being valued” or “provide meaningful substantive guidance” on how fair valuation determinations were to be made. It concludes with a finding that the independent directors caused “violations of Rule 38a-1.” The decision focuses less attention to the actual knowledge and good faith of the board than the mere absence of adequate procedures.

The Morgan Keegan directors were charged with not providing detailed instructions and guidance beyond the factors cited in previous SEC releases, despite the fact that the Director of the Investment Management Division had publicly stated six months earlier that “we believe there is a need to provide additional guidance on valuation of securities held by registered investment companies … because much has changed since the Commission last issued guidance”.17

New(ish) Commission Guidance. So, what was “new” in the guidance incorporated into the money market fund rule amendments in July 201418?

13 Compliance Programs of Investment Companies and Investment Advisers, Rel. Nos. IA-2204, IC-26299 (December 17, 2003)14 In the Matter of Jon D. Hammes, et al., Rel nos. 33-8346, IC-26290 (December 11, 2003).15 The independent directors were ordered to cease and desist from committing or causing violations of Sections 17(a)(2) or (3) of the Securities Act

or Rule 22c-1(a) of the Investment Company Act.16 In the Matter of J. Kenneth Alderman, CPA, et al., Rel.No. IC-30557 (June 13, 2013).17 Remarks to the ALI CLE 2012 Conference on Investment Adviser Regulation: Legal and Compliance Forum on Institutional Advisory Services by

Norm Champ (December 6, 2012).18 Money Market Fund Reform; Amendments to Form PF, Rel. No. 33-9616, IA-3879; IC-31166 (July 23, 2014)

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The Commission recognized formally that most money market securities – and indeed most fixed income securities – “are not actively traded in the secondary market.” The SEC acknowledged that “mark-to-model” or “matrix pricing” evaluations, rather than market prices, are used by funds to price such securities, and that most such evaluations are done by pricing services, rather than advisers. Since the goal of valuation at fair value continues to be determining what would be realized upon a “current sale,” pricing needs to take into account “market conditions existing” at the time of determination. The SEC’s 2014 guidance therefore emphasizes that fund directors, whose valuation responsibility is “non-delegable,” must assure themselves, if pricing services are being used, that their evaluations take market circumstances into account. Citing ASR 118’s “continuously review” and “all appropriate factors” standards, the 2014 guidance goes on to challenge directors to “consider the inputs, methods, models, and assumptions used” by its funds’ pricing services, and especially “how those inputs, methods, models, and assumptions are affected … as market conditions change.” To the extent that the board does not have a “good faith basis” to believe a service’s evaluated prices do not reflect “what the fund could reasonably expect to obtain for the securities in a current sale under current market conditions,” the SEC questions the “appropriateness” of the board’s reliance on that service provider.

As a result of the 2014 guidance, boards must obtain assurance from pricing services for income-based securities that they are using market prices as inputs and that the services recognize that their evaluations are to be judged by their accuracy at predicting sale prices. The SEC staff has suggested seeking “back-testing” results in this regard.

While the SEC’s comments can be seen as a logical extension and elaboration of existing guidance for fixed income securities, including money market instruments, the guidance is less clear and less helpful when it comes to other types of debt securities for which pricing services are used. Perhaps, that disparity explains why the SEC was surprised by the level of concern expressed with its updated guidance.

For example, floating rate instruments, such as bank loans, are expected to trade at par almost all the time, due to the periodic reset of interest rates. In distressed situations, the value of underlying collateral -- and the priority of the security in a waterfall structure -- should normally have a significant effect on the value of the security in a current sale. But since these matters are not “market-based” inputs, does the new guidance suggest that reliance on these significant underlying details is less appropriate than finding the price at which an instrument traded in a one-off sale in a limited market? The same issue occurs (perhaps even more so) for securitizations, where a deep understanding of the arrangement may be crucial to an assessment of core value, but markets may display periods of volatility or panic.

Directors understand, from Morgan Keegan and other enforcement proceedings, that fair values cannot be based on the portfolio manager’s override of, or pressure on, pricing services to reflect some hidden intrinsic value. However, the 2014 guidance reflects an emphasis on relatively simple, short-term instruments in the context where market prices are used as a stress test against a strictly formulaic approach. Money market funds rarely fail because their short-duration holdings are mispriced; usually, problems arise when there is an unexpected credit event.

The new guidance encourages the fund board to understand how varying considerations are weighted, but offers no help in the difficult

situation where the pricing service and the board need to evaluate whether a fire sale in under way. The SEC’s focus in 2014 on issues relevant to money market funds does not address the more difficult question about what to do in pricing municipal bonds when Goldman Sachs suddenly sells billions of dollars of its own holdings of such bonds in order to bolster its own liquidity, as happened in 2008. In other words, in a general liquidity crisis, must a fund board force everything to be precipitously marked down?

Liquidity and Pricing. More recently that its money fund guidance, the SEC has tackled issues of open-end funds’ ability to meet redemptions at stated net asset value in the Liquidity Proposal, with problematic effect. As previously stated, value is a matter set by statute. Market prices were to be used to encourage consistency and verifiability. The view stated by Chief Accountant of the Investment Management Division fifteen years ago was long-standing:

we do not believe it is appropriate to discount or mark-up a readily available market price for an unrestricted security solely because an investment company holds a large quantity of the outstanding shares of an issuer or holds an amount that is a significant portion of the security’s average daily trading volume.19

The Liquidity Proposal attempts to deal with the fact that a sale of a large position in a security will naturally drive down the market price of that security, at least temporarily. Furthermore, the resulting price drop will be incorporated into the fund’s NAV. In its current form, the Liquidity Proposal would require funds to calculate how much the price would drop if elimination of the security were staggered over the period necessary to complete the sale without materially affecting NAV, and to identify the portions that could be

disposed of over 1 business day, 2-3 business days, 4-7 calendar days, or 8-15, 16-30 or more than 30 calendar days (altogether, 6 “liquidity buckets”).

It must be noted that transaction costs have always been built into the returns of open-end funds when they are borne, i.e., on acquisition and disposition, rather than being conveyed through subjective adjustments to current net asset value calculations. Managing transaction costs is one of the valuable arts of portfolio management. At some times and for some securities, it is desirable to bear higher overall trading costs than the minimum if spread over all the necessary liquidity buckets.

Boards that have examined the Liquidity Proposal have naturally questioned whether a fund that has computed the transaction cost for disposing of a portfolio position can or should override the price at which that position is held. The idea that subsequent events in the foreign security context (such as trading activity in domestic markets) can make market prices other than “readily available” suggest that the next step would be to take anticipated events into account.

We believe that such a step would be one too far, and boards – and the SEC –

should refrain from considering such an outcome. It would mean that every fund would hold the same security at different prices, that might depend on the size of the position at the fund, within the accounts of the same portfolio manager, or at the fund complex at large. The Commission should recognize that liquidity is always an important element in trading markets, but that it is reflected in the size of the spread around the market price, not in the price itself.

19 Letter to Registrants from Chief Accountant of Division of Investment Management (Feb. 14, 2001)

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For further information please contact info@kramerlevin.com or visit www.kramerlevin.com

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Ronald M. Feiman advises clients on regulatory and compliance matters affecting investment companies and investment advisers. He provides legal counsel to service providers rendering distribution, custody and transfer agent services to registered and unregistered funds.

Mr. Feiman represents investment companies, investment advisers and investment company independent directors, as well as unregistered domestic and offshore debt and equity funds, in public and private offerings of equity and debt securities, proxy solicitations, and broker-dealer regulation and compliance. His clients include funds and directors of major mutual fund complexes, liquid alternative funds launched by independent managers and by major complexes, independent directors of listed closed-end funds, and funds of hedge funds, among other entities.

In addition, his corporate experience includes mergers and business combinations; stock and asset acquisitions; and recapitalizations, management buy-outs, and finance and venture capital transactions.

A certified public accountant as well as an attorney, Mr. Feiman has been recognized by Chambers USA and Legal 500 as a leading practitioner — a lawyer who is “very well-respected in the asset management industry” and lauded for his representation of independent directors and boards. (Chambers USA 2015)