Skip to main content

SEC ups the ante on ‘fair valuation’ game

Fund Boards should reconsider their fund oversight programs and technology in response to stricter regulation

In this era of ever higher market closes and recurring price swings, the market has become a bit exaggerated – some would say overly reactionary – at times. Not to mention that the global economy is still seeing uneven recovery from the biggest market fallout since the great depression. This is making shareholders question their current investments, in terms of their nature as well as their value.

These market forces have not gone unnoticed by regulators. For over 50 years, the SEC has had regulations on the books for mutual funds to provide for ‘fair value pricing’. This permits a mutual fund’s Board to value a security or asset ‘in good faith’ when a market quote is not readily available.

With the advent of new, more complex instruments, and the increased concentration of the average household’s savings in mutual funds being compounded by greater market volatility, the SEC has acted to modernize the ‘fair value’ process. The changes to valuation practices under the Investment Company Act of 1940 significantly redefine the responsibility of fund Boards for determining the fair value of a fund in good faith.

The goal of these new requirements is ensuring that the fund’s net asset value (NAV) is accurately priced on a daily basis. Accurate pricing should in turn support market transparency and stability while protecting investors.

Pricing challenges under the current model

In reality, the Board is not pricing mutual funds on a daily basis, but it is ultimately responsible for NAV accuracy. The fund administrator maintains the accounting general ledger and values the investments, normally using a third-party vendor to provide the market quotes or prices. Between the two parties they agree on a process for situations in which there are no “readily available market quotations” available for a given security.

This process includes specific policies based on the instrument type and may include alternative sources of information to be used. However, there is no prescribed regulation for this process, so there is the risk of inconsistencies. Unknowns include: are policies applied the same for all funds? How often are the policies reviewed? When should the fund administrator alert the Board to a new type of investment? Are there conflicts of interests that should be considered?

Lapses in any of these areas could lead to a bad price being used for an investment in a mutual fund and an incorrect NAV. Not only would that betray the trust of the existing shareholders in the fund, but all shareholder transactions would be wrong. In addition, compliance checks would be faulty, and violations could potentially go undetected.

"Lapses could lead to a bad price being used for an investment in a mutual fund and an incorrect NAV."

The Fund Oversight Challenge: Helping asset managers meet their NAV oversight, ESG, and data management obligations

Fair Valuation framework

To remedy this perilous situation, the SEC has adopted the Fair Valuation Rule (2a-5), which states that the Board or its valuation designee must:
•    assess and manage material risks associated with fair value determinations;
•    select, apply and test fair value methodologies; and 
•    oversee and evaluate any pricing services used.

Impact on Boards

Under the new requirements, the Board must become a much more active player in the integrity of the fund’s daily NAV. As part of their NAV oversight process, Boards will need to build out programs or functions to meet the demands of the new regulation in short order. It could take considerable time to put these in place from scratch, but I suspect Boards will look to leverage their existing infrastructure.

However, this does present an opportunity for Boards to do some of their own ‘modernization’ by adopting new technology. Points to consider include automating processes where possible and ensuring a robust audit trail.

Many firms using legacy systems will recognize that the SEC means business and they need to get their house in order. Since firms are already trying to cut costs they should look to technology as the solution to demonstrate compliance with this new rule. And relying on technology that has passed its shelf life or trying to repurpose other systems may not be the right approach to keep shareholders – and regulators – happy.

About the author, Matt Grinnell

Matt Grinnell is global product manager for Linedata software solutions, including fund oversight and compliance. A seasoned industry veteran, Matt’s focus is driving vision and strategy, working closely with clients and industry participants to discover and develop initiatives that grow customer value. Before joining Linedata, Matt worked at Fidessa for over a decade, where he was responsible for global product management and marketing of portfolio compliance and regulatory controls solutions. Prior to that he held compliance leadership roles at Putnam Investments and Fidelity and specialized in assessing the impact of new regulations and evaluating industry trends in risk and compliance.

NAV Oversight and Contingent NAV solutions

Volatile markets, remote working, and regulatory focus have exposed the risks posed by outdated NAV controls. If it’s time to rethink your NAV Oversight or Contingent NAV, think Linedata Navquest. It streamlines, standardizes, and automates daily checks of Net Asset Value calculations, providing clear metrics and reporting for audit, board, and regulatory purposes.

Connect with us today