SEC’s Fair Value Rule: Don’t Drop Old Guidance, Say Critics

The US Securities and Exchange Commission’s new proposed rule for fund managers to fair value some of their assets has prompted a vocal minority of legal and valuation experts to question whether the regulatory agency should entirely scrap older guidance in favor of new accounting rules as the barometer for valuation.

Fair value isn’t a new concept for fund management firms, which typically rely on valuation committees to price non-exchange traded financial instruments. What is different is the SEC’s prescriptive rules for how valuation should be accomplished. Based on responses to the SEC’s request for comments on its proposal due by July 21, it appears that many fund management firms approve of the SEC’s decision to rely on the Financial Accounting Standard Board’s ASC Topic 820 as the basis for fair-valuing some of their portfolio assets. However, critics question whether the metric is practical or even legal.

The SEC’s requirement for fund managers to use ASC Topic 820 comes as part of a broadreaching change in how fund management firms fair value their assets following the passage of the Investment Company Act of 1940 and subsequent guidance which put the onus of fair value valuation on fund board of directors with limited suggestions on methodologies to be used. The SEC’s goal is to eliminate Accounting Series Release (ASR) 113 issued in 1969 and ASR 118 issued the following year in favor of the new accounting standard. In addition, although boards of directors of funds can continue to oversee over the valuation process, they will be allowed to designate the work to registered investment advisers (RIAs) as long as the RIAs document and implement the SEC’s new required procedures. Those include quarterly reporting to boards of directors, establishing fair value methodologies, testing of those methodologies, and monitoring third-party pricing services.

The requirement to fair value portfolio securities under the SEC’s proposed Rule 2(a)5 would kick in when market quotations are not readily available. While the notion of fair value for such situations did apply under the Investment Company Act of 1940, the SEC never clearly explained what it meant by the phrase “readily available.” In its proposed rule, the SEC says that market prices are readily available only when the price quotation is a quoted price in an active market for identical circumstances. A quoted price is not readily available if it is unreliable. When is the quoted price unreliable? When it must be adjusted. Therefore, evaluated prices or those provided by third-party vendors are “not readily available,” says the SEC.

Unveiled in 2009, ASC Topic 820 offers a three-tiered approach to valuations based on which of three categories — Level One, Level Two, and Level Three–the asset in question is assigned. Assets in Level Two and Level Three are more difficult to value as there is no publicly agreed market price, which would typically be the case for an exchange-traded security. Level Two assets are those for which there are some observable inputs so a fund management firm can extrapolate prices for its assets using comparable assets. Level Three assets are those for which there are no observable inputs, so fund managers will have to make some tough judgment calls when creating new pricing models. Equities typically fall under Level One, while fixed-income securities and over-the-counter derivatives typically fall in either Level Two or Level Three depending on how frequently they are traded.

In responding to the SEC’s request for comment, the Washington, DC-based mutual fund trade group Investment Company Institute and numerous fund managers praised the regulatory agency’s decision to replace all previous guidance on valuation methodologies with ASC Topic 820. “The FASB’s accounting standards represent a more modern and comprehensive approach to valuation and accounting issues than do the ASRs,” writes Susan Olson, the ICI’s general counsel in a letter representing the majority viewpoint. Fund management firms appear to be far more concerned in following prescriptive rules on documentation and reporting, instead seeking some flexibility. They also want the SEC to permit them to use multiple valuation methodologies, rather than a single consistent methodology within a single asset class. “Application of methodologies should be dependent on facts and circumstances applied in a reasonable consistent manner when deemed appropriate and the Proposal fails to consider that certain investments, like private placements, may have unique features that do not support applying the same methodologies across the asset class,” write Brian Janssen, vice president and Nelson Lee, senior vice president and senior counsel of the Los Angeles-based Capital Research & Management Company who co-chair the firm’s fair valuation committee.

The chorus of support for using ASC Topic 820 would easily drown out any criticism, if it weren’t for the fact that the skeptics also have plenty of experience and solid reasoning to back their concerns. The Investment Company Act of 1940 which requires the pricing of assets using “fair value” never specifies methodologies and ASC Topic 820 was never designed for investment companies to calculate net asset valuations. Instead, the accounting rule was meant to produce audited financial statements, explains Barry Barbash, chairman of the New York City Bar Association’s Committee on Investment Management Regulation in its letter to the SEC.  In its letter to the SEC written by Robert Buckholz, a partner at the law firm of Sullivan & Cromwell in New York, the  American Bar Association’s Federal Regulation of Securities Committee, agrees saying, “Accounting rules are relevant to fund valuations to the extent that they provide a process for comparing a limited set of asset positions at the end of a fiscal period, a process that takes a considerable amount of time to complete (for funds up to 60 days after period end). By contrast, says the ABA’s committee, net asset valuations must be calculated on a daily basis.

In his comment letter to the SEC, Douglas Scheidt, former chief counsel and associate director of the SEC’s Division of Investment Management, is even more critical of the SEC’s decision to rely on ASC Topic 820 saying that the regulatory agency’s new rule is based on a flawed assumption. “It rests on the incorrect notion that the directors’ assignment of all of their statutory fair valuation duties to fund advises would be appropriate and consistent with the requirement of the {Investment Company] Act,” he writes. “The Act does not currently permit the fund directors to assign their fair valuation responsibilities to fund investment advisers. Indeed, it is prohibited under the Act.”

Legalities aside, there are several circumstances which ASC Topic 820 doesn’t address, say skeptics. One of those is the ongoing pricing of foreign securities, according to Barbash who is also senior counsel in the asset management group of Willkie Farr & Gallagher and a former director of the SEC’s Division of Investment Management. As he notes, the SEC’s proposed rule says that as the reporting entity– the RIA– shall not make an adjustment to Level One input except in certain circumstances. The regulatory agency narrowly defines those limited circumstances as transactions in a principal to principal market or trades in a brokered-market.

In his comment letter to the SEC, Scheidt cites other circumstances where ASC Topic 820 doesn’t provide any guidance, such as when pricing securities in index-based exchange-traded funds. Relying on stale closing prices might just be better than relying on fair-value to fair value exchange-traded portfolio securities. “The use of fair-values rather than closing prices would result in tracking-error, a divergence between the performance of the funds and the performance of the relevant index,” says Scheidt. “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.”

Unlike ASR 118, ASC Topic 820 also does not explain what fund managers should do when pricing portfolio securities based on the size of their holdings in a particular asset. To prove the shortcomings of such an omission, Scheidt points to the SEC’s enforcement actions against PIMCO, Investors Portfolio Management and Semper Capital Management for giving odd-lot positions higher valuations than larger round lot positions. The fund management firms failed to take into account the smaller sizes and lower values of the funds’ odd-lot positions. Had the fund management firms used ASC Topic 820 for their valuations they would never have been penalized, reasons Scheidt who recommends that the SEC provide valuation guidance on issues that are unique to investment funds and circumstances that ASC Topic 820 does not cover.

As if there weren’t enough problems with the legalities and exceptions to using ASC Topic 820, there are one other significant challenge which the SEC overlooked. Fund management board members may not even understand what it’s all about. “It seems to impose upon boards and other monitors of a fund’s pricing policies a level of knowledge of accounting rules that is well outside the scope of their responsibilities,” explains Barbash. In her comment letter to the SEC, Sandra Peters, senior head of global financial reporting policy for the CFA Institute, the Charlottesville, Virginia-headquartered global body responsible for certifying financial analysts, urges the SEC to mandate “valuation literacy” for investment company board members. “General financial literacy or even the existing financial literacy requirements for audit committee members is not sufficient to fully understand the complexities of valuation rules,” she says. Peters recommends that the SEC consider requiring board members to have minimum valuation literacy skills consisting of past work experience in valuation, professional certification or a comparable experience.

“One can learn enough to know about valuation, but it takes far longer to actually understand it and perspectives can differ depending on one’s training,” says George Haloulakos, a chartered financial analyst and president of Spartan Research, a San Diego-based firm specializing in valuation. “Certified public accountants understand the world through historic cost while certified financial analysts view the world through the different mathematical concepts of the true value of money and market value.” What about engineers? “They might understand the mathematics of valuation, but not have the intuition to know when to adjust prices based on contextual factors,” says Haloulakos who teaches valuation theory at the University of California at San Diego (Extension). Ultimately, he argues, intuition might even generate the same results as exhaustive quantitative analysis.

Given that using ASC Topic 820 has several shortcomings, critics recommend more flexibility. “Differences in valuations based on the application of different valuation methodologies should not expose funds and boards to any greater threat of liability than already exists,” says Barbash. “Accounting literature can be recommended for review by advisers and boards in creating valuation policies and procedures, but we submit that the proposed rule should not require adherence to such literature. “The Committee believes that a better approach than incorporating accounting literature would be for the Commission to reissue and update ASR 113 and ASR 118 rather than withdraw them as proposed.” Scheidt takes a similar stance saying  “At a minimum, the Commission should preserve the interpretative guidance in ASR 118 that expressly permit each fund board to appoint persons to assist them in making fair value determinations, and to make the actual calculations pursuant to the board’s directions.” Relying on RIAs to do the all the valuation work is a remedy for disaster because conflicts of interest could easily occur, according to Scheidt who compares the idea to allowing the fox to be in charge of the henhouse. In its letter to the SEC written by Sullivan & Cromwell’s Buckholz, the ABA’s Federal Regulation of Securities Committee recommends rescinding the regulatory agency’s previous guidance yet suggests that when the SEC finalizes its new rule it includes “acknowledgement that fair values arrived in good faith that differ from what’s subsequently viewed as appropriate from an accounting point of view does not result in fund director liabilities.”

Since it is unlikely the SEC will change its mind about using ASC Topic 820 regardless of any other tweaks it makes to its proposed fair value rule, fund management firms will just have to adjust. “Registered investment advisers were likely relying on ASC Topic 820 to classify their assets, but might not have always used the suggested methodologies of each category in pricing them,” Barbash tells FinOps Report. How hard relying on the new accounting guideline will be depends on the previous methodology used. In its proposed rule, the SEC never discusses the technical challenges fund management firms will face nor does it mention the possible impact to investors based on changes to net asset valuations or performance results. Presumably, the regulatory agency either isn’t concerned or doesn’t think there will be much of a difference for fund management firms or investors. The documentation and reporting requirements could well end up being the most challenging aspects of complying with the new proposed rule, when effective, several operations directors at US fund management shops tell FinOps Report.

Administrative work aside, fund management firms will also shoulder one more burden should board of directors need a crash course in ASC Topic 820. “Fund management firms will likely end up having to educate boards of directors on ASC Topic 820 by explaining the methodology in greater depth providing examples using different assets,” says Barbash. Fortunately, board of directors don’t have to understand all the intricacies of ASC Topic 820 as they aren’t the ones crunching the numbers on a daily basis. “If nothing else, board of directors need to know that valuations are ultimately situational and impacted by market conditions, industry nuances, investor psychology, economic cycles and other factors,” says Haloulakos.

If the SEC has its way, it will adopt the new Rule 2(a)5 in October, giving fund management firms one-year to comply. Should some fund management shops have their way, the transition could last eighteen months leaving fund managers with plenty of time to generate Cliff Notes for their boards of directors. Still, they may need to prepare sooner rather than later. “Fund management boards could start learning the specifics of how to apply the new rule from registered investment advisers in early 2021,” says Barbash.