AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is proposing a new rule (“rule 2a-5”) under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”) that would address valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company (a “fund”). The proposed rule would provide requirements for determining fair value in good faith with respect to a fund for purposes of section 2(a)(41) of the Act. This determination would involve assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records. The proposed rule would permit a fund's board of directors to assign the fair value determination to an investment adviser of the fund, who would then carry out these functions for some or all of the fund's investments. This assignment would be subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability effectively to oversee the adviser's fair value determinations. The proposed rule would include a specific provision related to the determination of the fair value of investments held by unit investment trusts, which do not have boards of directors. The proposed rule would also define when market quotations are readily available under section 2(a)(41) of the Act. If rule 2a-5 is adopted, the Commission would rescind previously issued guidance on the role of the board of directors in determining fair value and the accounting and auditing of fund investments.

DATES:

Comments should be submitted on or before July 21, 2020.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (http://www.sec.gov/​rules/​interp.shtml); or
• Send an email to rule-comments@sec.gov. Please include File Number S7-07-20 on the subject line.

Paper Comments

• Send paper comments to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-07-20. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website (http://www.sec.gov/​rules/​interp.shtml). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make publicly available.

Studies, memoranda or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Joel Cavanaugh, Senior Counsel; Bradley Gude, Senior Counsel; Thoreau A. Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management; Kieran G. Brown, Senior Counsel, or David J. Marcinkus, Branch Chief, at (202) 551-6825 or IMOCC@sec.gov, Chief Counsel's Office, Division of Investment Management; Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-8549. Regarding accounting and auditing matters: Jenson Wayne or Alexis Cunningham, Assistant Chief Accountants, or Jacob Sandoval, Branch Chief, at (202) 551-6918 or IM-CAO@sec.gov, Chief Accountant's Office, Division of Investment Management, Securities and Exchange Commission; or Jamie Davis or Thomas Collens, Professional Accounting Fellows, at (202) 551-5300 or OCA@sec.gov, Office of the Chief Accountant, Securities and Exchange Commission.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment 17 CFR 270.2a-5 (new rule 2a-5) under the Investment Company Act.

Table of Contents

I. Introduction

II. Discussion

A. Fair Value as Determined in Good Faith Under Section 2(a)(41) of the Act

1. Valuation Risks

2. Fair Value Methodologies

3. Testing of Fair Value Methodologies

4. Pricing Services

5. Fair Value Policies and Procedures

6. Recordkeeping

B. Performance of Fair Value Determinations

1. Board Oversight

2. Board Reporting

3. Specification of Functions

4. Records of Assignment

C. Readily Available Market Quotations

D. Rescission of Prior Commission Releases

E. Existing Staff No-Action Letters, Other Staff Guidance, and Proposed Transition Period

III. Economic Analysis

A. Introduction

B. Economic Baseline

1. Current regulatory framework

2. Current practices

3. Affected parties

C. Benefits and Costs and Effects on Efficiency, Competition, and Capital Formation of Proposed Rule

1. General Economic Considerations

2. Benefits

3. Costs

4. Effects on Efficiency, Competition, and Capital Formation

D. Reasonable Alternatives

1. More Principles-Based Approach

2. Assignment of Responsibilities to Service Providers Other Than Investment Advisers

3. Not Permit Boards To Assign Fair Value Determinations to an Investment Adviser

E. Request for Comment

IV. Paperwork Reduction Act Analysis

A. Introduction

B. Policies and Procedures

C. Board Reporting

D. Recordkeeping

E. Proposed Rule 2a-5 Total Estimated Burden

F. Request for Comment

V. Initial Regulatory Flexibility Analysis

A. Reasons for and Objectives of the Proposed Actions

B. Legal Basis

C. Small Entities Subject to Proposed Rules

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Policies and Procedures

2. Recordkeeping

3. Board Reporting

E. Duplicative, Overlapping, or Conflicting Federal Rules

F. Significant Alternatives

G. Request for Comment

VI. Consideration of Impact on the Economy

VII. Statutory Authority

I. Introduction

The Investment Company Act requires funds to value their portfolio investments using the market value of their portfolio securities when market quotations for those securities are “readily available,” and, when a market quotation for a portfolio security is not readily available, by using the fair value of that security, as determined in good faith by the fund's board.^[1] The aggregate value of a fund's investments is the primary determinant of the fund's net asset value (“NAV”), which for many funds determines the price at which their shares are offered and redeemed (or repurchased).^[2] Accordingly, proper valuation, among other things, promotes the purchase and sale of fund shares at fair prices, and helps to avoid dilution of shareholder interests.^[3] Valuation also affects the accuracy of funds' asset-based and performance-based fee calculations; ^[4] disclosures of fund fees, performance, NAV, and portfolio holdings; ^[5] and compliance with investment policies and limitations.^[6] As a result, improper valuation can cause investors to pay fees that are too high or to base their investment decisions on inaccurate information.^[7]

For these reasons, a number of the substantive requirements of the Investment Company Act relate to investment company valuation.^[8] Moreover, the federal securities laws impose liability on funds, fund boards, and advisers for improperly valuing fund investments and for making material misstatements regarding a fund's valuation procedures.^[9] Properly valuing a fund's investments also is a critical component of the accounting and financial reporting for investment companies.^[10] Section 2(a)(41)(B) defines “value” for purposes of many of the requirements of the Investment Company Act as: (i) With respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors.^[11]

The Commission last comprehensively addressed valuation under the Investment Company Act in a pair of releases issued in 1969 and 1970, Accounting Series Release 113 (“ASR 113”) and Accounting Series Release 118 (“ASR 118”).^[12] ASR 113 addressed a number of federal securities law and accounting topics related to the purchase of restricted securities by funds, including how to determine fair value ^[13] for such securities. A year later, ASR 118 expressed the Commission's views on certain valuation matters, including accounting and auditing, as well as the role of the board in the determination of fair value.

The Commission acknowledged in ASR 113 and ASR 118 that the board need not itself perform each of the specific tasks required to calculate fair value in order to satisfy its obligations under section 2(a)(41). However, under ASR 113 and ASR 118 the board chooses the methods used to arrive at fair value, and continuously reviews the appropriateness of such methods.^[14] In addition, the Commission stated that boards should consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available.^[15] Finally, the Commission stated that whenever technical assistance is requested from individuals who are not directors, the findings of such individuals must be carefully reviewed by the directors in order to satisfy themselves that the resulting valuations are fair.^[16]

Since ASR 113 and ASR 118 were issued, markets and fund investment practices have evolved considerably. Funds now invest in a greater variety of securities and other instruments, some of which did not exist in 1970 and may present different and more significant valuation challenges.^[17] Furthermore, advances in communications and technology have greatly enhanced the availability and currency of pricing information.^[18] Today there is a greater volume of data available that may bear on determinations of fair value, and new technologies have developed that facilitate enhanced price discovery and greater transparency.^[19] Many funds also now engage third-party pricing services to provide pricing information, particularly for thinly traded or more complex assets.^[20]

In addition, three significant regulatory developments since 1970 have fundamentally altered how boards, advisers, independent auditors (also referred to herein as “independent accountants”), and other market participants address valuation for various purposes under the federal securities laws.

The first such development was the enactment of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) and the adoption of rules mandated by the Sarbanes-Oxley Act.^[21] In particular, the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (“PCAOB”). The PCAOB oversees the audits of companies that are subject to the federal securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.^[22] The PCAOB also has the authority to establish or adopt, among other things, professional standards, including audit and quality controls standards, to be used by registered public accounting firms in the preparation and issuance of audit reports.^[23] In addition, section 108 of the Sarbanes-Oxley Act established criteria necessary for the work product of an accounting standard-setting body to be recognized as “generally accepted” for purposes of the federal securities laws.^[24] Rule 30a-3 under the Investment Company Act, which was adopted in part to implement certain requirements of the Sarbanes-Oxley Act, requires registered management investment companies to maintain disclosure controls and procedures and internal control over financial reporting.^[25]

Second was the adoption in 2003 of compliance rules under the Investment Company Act and the Advisers Act (together, the “Compliance Rules”).^[26] The Compliance Rules were designed to enhance compliance with the federal securities laws by requiring funds and advisers to adopt and implement written compliance policies and procedures that are reasonably designed to prevent violation of the federal securities laws, to review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and to designate a chief compliance officer (“CCO”) to be responsible for administering them.^[27] Of particular relevance, the Commission stated that rule 38a-1 requires a fund to adopt compliance policies and procedures with respect to fair value that require the fund to:

1. Monitor for circumstances that may necessitate the use of fair value;

2. establish criteria for determining when market quotations are no longer reliable for a particular portfolio security;

3. provide a methodology or methodologies by which the fund determines fair value; and

4. regularly review the appropriateness and accuracy of the methodology used to determine fair value, and make any necessary adjustments.^[28]

Third was the issuance and codification by the Financial Accounting Standards Board (“FASB”) of ASC Topic 820 in 2006 and 2009.^[29] ASC Topic 820 defines the term “fair value” for purposes of the accounting standards ^[30] and establishes a framework for the recognition, measurement, and disclosure of fair value under U.S. generally-accepted accounting principles (“U.S. GAAP”).^[31]

Taken together, we believe these regulatory developments have significantly altered the framework in which funds, boards, fund investment advisers, other fund service providers such as pricing services, and auditors perform various functions relating to fair value determinations. We believe that today determining fair value often requires greater resources and expertise than when the Commission issued ASR 113 and ASR 118 roughly fifty years ago. In addition, we believe that regulatory changes during that period have altered the way that boards, fund investment advisers, other fund service providers, and auditors address valuation. Our views are also informed by significant outreach that the staff has conducted with funds, investment advisers, audit firms, trade groups, fund directors, and others, particularly over the past two years. As part of these discussions, many boards sought additional clarity on how they can effectively fulfill their fair value determination obligations while seeking the assistance of others. The staff understands that this is of particular focus in light of the increased complexity of many fund portfolios and the in-depth expertise required to accurately fair value such complex investments.

In recognition of these changes, we are proposing a new rule to reflect the increased role that subsequent accounting and auditing developments play in setting fund fair value practices, as well as the growing complexity of valuation and the interplay of the compliance rule in facilitating board oversight of funds. The proposed rule also acknowledges the important role that fund investment advisers now play and expertise they now provide in the fair value determination process given these and other developments.

II. Discussion

The proposed rule would provide requirements for determining fair value in good faith with respect to a fund for purposes of section 2(a)(41) of the Act and rule 2a-4 thereunder.^[32] We believe that, in light of the developments discussed above, to determine the fair value of fund investments in good faith requires a certain minimum, consistent framework for fair value and standard of baseline practices across funds, which would be established by the proposed rule. The proposed rule would also permit a fund's board to assign fair value determinations to an investment adviser of the fund.^[33] Permitting a fund's board to assign fair value determinations to an investment adviser is designed to recognize the developments discussed above, including the important role that fund investment advisers now play and expertise they now provide in the fair value determination process, given these developments. However, when a fund's board uses the services of a fund investment adviser as part of the fair value determination process, we believe it is particularly important to establish a framework for boards to effectively oversee the investment adviser through the proposed rule, in light of the adviser's conflicts of interest and given that, in these circumstances, the fund's board would satisfy its statutory obligation to determine fair value in good faith through the framework of the proposed rule, including this board oversight.

Accordingly, under the proposed rule, fair value as determined in good faith would require assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; overseeing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records.^[34] These required functions generally reflect our understanding of current practices used by funds to fair value their investments and we discuss each in detail below. When a board assigns the determination of fair value to an adviser for some or all of the fund's investments under the proposed rule, in addition to board oversight, the rule would include certain reporting, recordkeeping, and other requirements designed to facilitate the board's oversight of the adviser's fair value determinations.^[35]

The proposed rule would apply to all registered investment companies and BDCs, regardless of their classification or sub-classification (e.g., open-end funds and closed-end funds, including BDCs ^[36] ), or their investment objectives or strategies (e.g., equity or fixed income; actively managed or tracking an index).^[37] In the case of a unit investment trust (“UIT”), because a UIT does not have a board of directors or investment adviser, a UIT's trustee would conduct fair value determinations under the proposed rule.^[38]

We are also proposing to rescind ASR 113 and 118, which provide guidance on, among other things, the role of the fund board in fair value determinations as well as guidance on certain accounting and auditing matters. In addition, the staff letters related to the board role in the fair value process would be withdrawn as discussed in section II.E below.^[39]

A. Fair Value as Determined in Good Faith Under Section 2(a)(41) of the Act

We discuss below each of the required functions set forth in proposed rule 2a-5(a) that must be performed to determine in good faith the fair value of the fund's investments.^[40]

1. Valuation Risks

Proposed rule 2a-5 would provide that determining fair value in good faith requires periodically assessing any material risks associated with the determination of the fair value of the fund's investments, including material conflicts of interest, and managing those identified valuation risks.^[41] We believe that assessing and managing identified valuation risks is an important element for determining fair value in good faith because ineffectively managed valuation risks can make it more likely that a board or an adviser may incorrectly value an investment.

There are many potential sources of valuation risk. A non-exhaustive list of the types or sources of valuation risk includes:

• The types of investments held or intended to be held by the fund;
• potential market or sector shocks or dislocations; ^[42]

• the extent to which each fair value methodology uses unobservable inputs, particularly if such inputs are provided by the adviser; ^[43]

• the proportion of the fund's investments that are fair valued as determined in good faith, and their contribution to the fund's returns;
• reliance on service providers that have more limited expertise in relevant asset classes; the use of fair value methodologies that rely on inputs from third party service providers; and the extent to which third party service providers rely on their own service providers (so-called “fourth party” risks); and
• the risk that the methods for determining and calculating fair value are inappropriate or that such methods are not being applied consistently or correctly.

Other than material conflicts of interest, the proposed rule does not identify the specific valuation risks to be addressed under this requirement. Rather, we believe that specific valuation risks would depend on the facts and circumstances of a particular fund's investments. The proposed rule also does not include a specific frequency for the required periodic re-assessment of a fund's valuation risks, as we believe that different frequencies may be appropriate for different funds or risks. We believe that the periodic re-assessment of valuation risk generally should take into account changes in fund investments, significant changes in a fund's investment strategy or policies, market events, and other relevant factors.

We request comment on the proposal to require the assessment and management of the material risks associated with fair value determinations.

1. Is this requirement appropriate? Should we further define what risks would need to be considered or provide guidance on the types of valuation risks that a fund may face? Are there additional sources or types of valuation risk that we should address? If so, what sources?

2. Should we require a certain minimum frequency for re-assessing valuation risk (e.g., annually or quarterly)? Should the rule specify types of market events or investment strategy changes that would require a re-assessment of valuation risk? If so, what events or changes should prompt such a review?

3. Should we provide any further guidance on how valuation risk should be managed?

2. Fair Value Methodologies

Proposed rule 2a-5 would provide that fair value as determined in good faith requires selecting and applying in a consistent manner an appropriate methodology or methodologies ^[44] for determining (which includes calculating) the fair value of fund investments. This requirement would include specifying (1) the key inputs and assumptions specific to each asset class or portfolio holding, and (2) the methodologies that will apply to new types of investments in which the fund intends to invest.^[45] The proposed rule also would require the selected methodologies to be periodically reviewed for appropriateness and accuracy, and to be adjusted if necessary. Selecting and applying a methodology consistently—and reviewing the methodology and adjusting it if necessary—are all important elements to determining fair value in good faith.^[46] This is because an inappropriate methodology, or a methodology that is applied inconsistently, increases the likelihood that a fund's investments will be improperly valued.

Currently, ASC Topic 820 refers to valuation approaches, including the market approach, income approach, and cost approach, as well as valuation techniques and methods as ways in which to measure fair value.^[47] To be appropriate under the rule, and in accordance with current accounting standards, a methodology used for purposes of determining fair value must be consistent with ASC Topic 820, and thus derived from one of these approaches. We recognize, however, that there is no single methodology for determining the fair value of an investment because fair value depends on the facts and circumstance of each investment, including the relevant market and market participants.^[48]

Proposed rule 2a-5 also would require that the board or adviser consider the applicability of the selected fair value methodologies to types of fund investments that a fund does not currently hold but in which it intends to invest in the future.^[49] This requirement is designed to facilitate the effective determination of the fair value of these new investments by the board or adviser. In addition, the proposed rule would require periodic reviews of the selected fair value methodologies for appropriateness and accuracy, and adjustments to the methodologies where necessary. For example, the results of back-testing or calibration (as discussed below) or a change in circumstances specific to an investment could necessitate adjustments to a fund's fair value methodologies.^[50] As discussed above, while the proposed rule would require that the fair value methodologies be consistently applied to the asset classes for which they are relevant, there can be circumstances where it is appropriate to adjust methodologies if the adjustments would result in a measurement that is equally or more representative of fair value.^[51] The proposed rule's requirement to apply fair value methodologies in a consistent manner would not preclude the board or adviser from changing the methodology for an investment in such circumstances.^[52]

The proposed rule also would require the board or adviser to monitor for circumstances that may necessitate the use of fair value as determined in good faith.^[53] The use of fair value is required when market quotations are not readily available. The rule would require the establishment of criteria for determining when market quotations no longer are reliable, and therefore are not readily available.^[54] For example, if a fund invests in securities that trade in foreign markets, the board or adviser generally should identify and monitor for the kinds of significant events that, if they occurred after the market closes in the relevant jurisdiction but before the fund prices its shares, would materially affect the value of the security and therefore may suggest that market quotations are not reliable.^[55]

We continue to believe that for any particular investment there may be a range of appropriate values that could reasonably be considered to be fair value, and whether a specific value should be considered fair value will depend on the facts and circumstances of the particular investment. Accordingly, we expect that the methodologies used may reflect this range of potential fair values and result in unbiased determinations of fair value within the range.

We request comment on the proposed requirement to establish and apply the methodologies for determining and calculating fair value.

4. This requirement includes several specified elements, discussed above, relating to the fair value methodologies. Are these elements appropriate? Are there additional elements that commenters believe should be included under this requirement? Should we modify or remove any of the proposed elements? Should we require application of the methodologies in a reasonably consistent manner, or as consistently as possible under the circumstances?

5. Do commenters believe we should provide additional guidance relating to this requirement? If so, on which elements of the proposed requirement should we provide additional guidance? For example, is the proposed requirement that boards or advisers “select” a methodology sufficiently clear?

6. Are there investments for which it is not feasible to establish a methodology in advance? If so, how should the rule address such situations? Is it clear what new investment types a fund may “intend” to invest in? Should we provide any further guidance on this? What processes do funds currently follow before investing in new types of investments to help to ensure that, after making the investment, the board will be in a position to determine fair value if required?

3. Testing of Fair Value Methodologies

The proposed rule would require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value.^[56] This requirement is designed to help ensure that the selected fair value methodologies are appropriate and that adjustments to the methodologies are made where necessary. We believe that the specific tests to be performed and the frequency with which such tests should be performed are matters that depend on the circumstances of each fund and thus should be determined by the board or the adviser. The proposed rule would require the identification of (1) the testing methods to be used, and (2) the minimum frequency of the testing.^[57] We believe that the results of calibration and back-testing can be particularly useful in identifying trends, and also have the potential to assist in identifying issues with methodologies applied by fund service providers, including poor performance or potential conflicts of interest.^[58] For example, if a specific methodology consistently over-values or under-values one or more fund investments as compared to observed transactions, the board or adviser should investigate the reasons for this difference. We recognize, however, that back-testing may be less useful for portfolio holdings that trade infrequently.^[59]

We request comment on the proposed rule's requirement to test the appropriateness and accuracy of the fair value methodologies.

7. Should the rule require particular testing types or minimum testing frequencies? For example, should we require tests to occur at least weekly, monthly, or quarterly? If so, should the frequency required be dependent upon the type of instrument? Should the rule require all funds to use certain types of testing, such as back testing and calibration, at a minimum? Are certain types of methodology testing inappropriate or irrelevant for certain investment types?

8. What other types of testing of fair value methodologies are commonly used?

9. Should the rule require specified actions based on the results of the testing? If so, what would those actions be?

4. Pricing Services

To obtain valuation information, particularly for thinly traded or more complex assets, pricing services, may be used. Pricing services are third-parties that regularly provide funds with information on evaluated prices, matrix prices, price opinions, or similar pricing estimates or information to assist in determining the fair value of fund investments.^[60] Accordingly, the proposed rule would provide that determining fair value in good faith requires the oversight and evaluation of pricing services, where used.^[61] This provision is designed to help ensure that pricing information received from pricing services serves as a reliable input for determining fair value in good faith.

For funds that use pricing services, the proposed rule would require that the board or adviser establish a process for the approval, monitoring, and evaluation of each pricing service provider. The board or adviser generally should take into consideration factors such as (i) the qualifications, experience, and history of the pricing service; (ii) the valuation methods or techniques, inputs, and assumptions ^[62] used by the pricing service for different classes of holdings, and how they are affected as market conditions change; (iii) the pricing service's process for considering price “challenges,” ^[63] including how the pricing service incorporates information received from pricing challenges into its pricing information; (iv) the pricing service's potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and (v) the testing processes used by the pricing service.

In addition, there may be times when pricing information from a pricing service differs materially from the board's or adviser's view of the fair value of the investment, and the board or adviser may seek to contact the pricing service to question the basis for the pricing information. As such, the proposed rule would require the establishment of criteria for the circumstances under which price challenges typically would be initiated (e.g., establishing objective thresholds).

We request comment on the proposed rule's requirement to oversee pricing services.

10. Do commenters agree that the proposed rule should require oversight of pricing service providers, if used? Should the rule cover any service providers other than pricing services? If so, which service providers should be included? Should the rule further clarify who qualifies as a pricing service?

11. Should there be a specific requirement in the rule to periodically review the selection of the pricing services used and to evaluate other pricing services?

5. Fair Value Policies and Procedures

Proposed rule 2a-5 would require written policies and procedures addressing the determination of the fair value of the fund's investments (“fair value policies and procedures”).^[64] The proposed rule would require the fair value policies and procedures to be reasonably designed to achieve compliance with the requirements of proposed rule 2a-5 discussed above. Requiring fair value policies and procedures that would be tailored to the proposed rule's requirements would help to ensure that a board or adviser, as applicable, determines the fair value of fund investments in compliance with the rule. Under the proposed rule, where the board determines the fair value of investments, the board-approved fair value policies and procedures would be adopted and implemented by the fund. Where the board assigns fair value determinations to the adviser under proposed rule 2a-5(b), as discussed in section II.B, the fair value policies and procedures would be adopted and implemented by the adviser, subject to board oversight under rule 38a-1.^[65]

Rule 38a-1 also would apply to a fund's obligations under the proposed rule. Rule 38a-1 requires a fund's board, including a majority of its independent directors, to approve the fund's policies and procedures, including those on fair value, and those of each investment adviser and other specified service providers, based upon a finding by the board that the policies and procedures are reasonably designed to prevent violation of the federal securities laws.^[66] Rule 38a-1 also requires that the fund's CCO provide an annual report to the fund's board ^[67] that must address any material changes to compliance policies and procedures.^[68] Rule 38a-1 would encompass a fund's compliance obligations with respect to proposed rule 2a-5, if adopted, and would require a fund's board to oversee compliance with the rule.^[69] To the extent that adviser policies and procedures under proposed rule 2a-5 would otherwise be duplicative of fund valuation policies under rule 38a-1,^[70] a fund could adopt the rule 2a-5 policies and procedures of the adviser in fulfilling its rule 38a-1 obligations.

We request comment on the proposed fair value policies and procedures requirement.

12. Are there specific elements that the proposed fair value policies and procedures should include other than the required elements of proposed rule 2a-5(a)?

13. Are we sufficiently clear on the interaction between rule 38a-1 and the policies and procedures under proposed rule 2a-5? Should we provide any further guidance on their interaction?

6. Recordkeeping

Proposed rule 2a-5 would require that the fund maintain certain records.^[71] Specifically, the proposed rule would require the maintenance of:

• Supporting Documentation. Appropriate documentation to support fair value determinations, including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations, as well as any necessary or appropriate adjustments in methodologies, for at least five years from the time the determination was made, the first two years in an easily accessible place; and
• Policies and Procedures. A copy of policies and procedures that would be required under the proposed rule that are in effect, or that were in effect at any time within the past five years, in an easily accessible place.

Funds and advisers currently are required to retain certain documentation related to fund valuation.^[72] Documents often provide the primary means to demonstrate whether portfolio holdings have been valued in a manner consistent with applicable law, any valuation compliance policies and procedures, and any disclosures. They also provide evidence to the fund's auditors in performing their duties related to the audit of the fund's financial statements and assist the fund's CCO in the preparation of compliance reports to the board. The Commission has brought enforcement actions in cases where it alleged that appropriate documentation relating to valuation was not maintained by a fund or adviser or obtained by auditors.^[73]

The proposed requirement to maintain appropriate documentation to support fair value determinations would include documentation that would be sufficient for a third party to verify the fair value determination. We understand that advisory personnel currently produce working papers supporting fair value determinations that include, for example, calibration and back-testing data as well as other information such as stale price analysis.^[74] These records would be required to be maintained as supporting fair value determinations.^[75]

We believe that it is appropriate for the proposed rule to include a recordkeeping provision to facilitate compliance with the proposed rule and to permit effective regulatory oversight. The proposed retention periods are designed to be consistent with the recordkeeping requirements in rule 38a-1(d), the compliance rule. As discussed above, the compliance rule requires the retention of, among other things, compliance policies and procedures (which would include those relating to valuation) and certain records.^[76] We believe that this recordkeeping requirement would provide important investor protections and, because it would be consistent with current record retention practices under to rule 38a-1(d), would not impose overly burdensome recordkeeping costs.

We request comment on the proposed recordkeeping provisions.

14. Are there any additional types of records that we should require? If so, which records and why?

15. Where the board assigns fair value determinations to an adviser under proposed rule 2a-5(b), should the rule require the adviser, rather than the fund, to maintain these records?

16. Are the proposed retention periods sufficient to evidence compliance? Why or why not? Should we require a longer (e.g., six years) or shorter (e.g., four years) retention period?

17. Are key terms used in this aspect of the proposal sufficiently understandable? For example, as stated above, “appropriate documentation to support fair value determinations” under the proposed recordkeeping requirement would include documentation that would be sufficient for a third party to verify the fair value determination. Should we define these or other terms or provide further guidance relating to them?

B. Performance of Fair Value Determinations

The Act assigns boards a critical role in connection with determinations of fair value.^[77] Although the Commission has previously taken the position that a fund's board may not delegate the determination of fair value to anyone else,^[78] the Commission has also recognized that compliance with the Act does not require the board to perform each of the specific tasks required to calculate fair value itself.^[79] We believe that the Commission's prior guidance recognized that determinations of fair value often require significant resources and specialized expertise, and that in many cases it may be impracticable for directors themselves to perform every one of the necessary tasks without assistance. We expect that today determining fair value requires even greater resources and expertise than when ASR 113 and ASR 118 were issued. For this reason, in addition to providing requirements for determining fair value in good faith generally, the proposed rule also is designed to provide boards and advisers with a consistent, modern approach to the allocation of fair value functions, while also preserving a crucial role for boards to fulfill their obligations under section 2(a)(41) of the Act.

Under the proposed rule, a board may choose to determine fair value in good faith for any or all fund investments by carrying out all of the functions required in paragraph (a) of the proposed rule, including, among other things, monitoring for circumstances that necessitate fair value, selecting valuation methodologies, and applying those methodologies.^[80] However, a board would not be required to take this approach. We understand that, for practical reasons, few boards today are directly involved in the performance of the day-to-day valuation tasks required to determine fair value. Instead they enlist the fund's investment adviser to perform certain of these functions, subject to their supervision and oversight.^[81]

This allocation of functions is consistent with the framework created by the ASRs. We continue to believe that allocating day-to-day responsibilities to an investment adviser, subject to robust board oversight, is appropriate and consistent with the requirements of Act. The proposed rule is designed to provide a consistent framework for this allocation between boards and advisers, and to provide enhanced protections which we believe are consistent with the more modern approaches to fair value and compliance with the federal securities laws described below.

Accordingly, the proposed rule would permit a fund's board of directors to assign the fair value determination relating to any or all fund investments to an investment adviser of the fund, which would carry out all of the functions required in paragraph (a) of the proposed rule, subject to certain requirements enumerated in proposed paragraph (b).^[82] A fund's board could make this assignment to a fund's primary adviser or one or more sub-advisers. For example, for a fund with a sub-adviser responsible for managing a portion of the fund's portfolio, the board could assign the determination of fair value for the investments in that portion of the fund's portfolio to that sub-adviser. As a result, a multi-manager fund could have multiple advisers assigned the role of determining fair value of the different investments that those advisers manage. Where the board assigns fair value determinations to multiple advisers, the fund's policies and procedures adopted under rule 38a-1 should address the added complexities of overseeing multiple assigned advisers in order to be reasonably designed to avoid violating the federal securities laws.^[83] Any board assignment under the proposed rule would be subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability effectively to oversee the adviser's fair value determinations. We discuss each of these requirements below.

We request comment generally on the role of the board of directors when it does not assign the fair value determination to an adviser to the fund.

18. For boards that elect to conduct fair value determinations themselves, should we provide any guidance on the level of assistance they can receive from service providers, while fulfilling their obligations under section 2(a)(41)? Do we need to provide any guidance on how a board should obtain and oversee such assistance if needed? If so, what guidance should we provide?

1. Board Oversight

Where the board assigns fair value determinations to an adviser, the proposed rule would require the board to satisfy its statutory obligation with respect to such determinations by overseeing the adviser. Boards should approach their oversight of fair value determinations assigned to an investment adviser of the fund with a skeptical and objective view that takes account of the fund's particular valuation risks, including with respect to conflicts, the appropriateness of the fair value determination process, and the skill and resources devoted to it.^[84] Further, in our view effective oversight cannot be a passive activity. Directors should ask questions and seek relevant information. The board should view oversight as an iterative process and seek to identify potential issues and opportunities to improve the fund's fair value processes.^[85] The proposed rule would require the adviser to report to the board with respect to matters related to the adviser's fair value process, in part to ensure that the board has sufficient information to conduct this oversight.^[86] Boards should also request follow up information when appropriate and take reasonable steps to see that matters identified are addressed.^[87]

We would expect that boards engaged in this process would use the appropriate level of scrutiny based on the fund's valuation risk, including the extent to which the fair value of the fund's investments depend on subjective inputs. For example, a board's scrutiny would likely be different if a fund invests in publicly traded foreign companies than if the fund invests in private early stage companies. As the level of subjectivity increases and the inputs and assumptions used to determine fair value move away from more objective measures, we expect that the board's level of scrutiny would increase correspondingly.^[88]

We also believe that, consistent with their obligations under the Act and as fiduciaries, boards should seek to identify potential conflicts of interest, monitor such conflicts, and take reasonable steps to manage such conflicts.^[89] In so doing, the board should serve as a meaningful check on the conflicts of interest of the adviser and other service providers involved in the determination of fair values.^[90] In particular, the fund's adviser may have an incentive to improperly value fund assets in order to increase fees, improve or smooth reported returns, or comply with the fund's investment policies and restrictions.^[91] Other service providers, such as pricing services or broker-dealers providing opinions on prices, may have incentives (such as maintaining continuing business relationships with the adviser) or may otherwise be subject to pressures to provide pricing estimates that are favorable to the adviser.^[92] In overseeing the adviser's process for making fair value determinations, the board should understand the role of, and inquire about conflicts of interest regarding, any other service providers used by the adviser as part of the process, and satisfy itself that any conflicts are being appropriately managed.

Boards should probe the appropriateness of the adviser's fair value processes. In particular, boards should periodically review the financial resources, technology, staff, and expertise of the assigned adviser, and the reasonableness of the adviser's reliance on other fund service providers, relating to valuation.^[93] In addition, boards should consider the adviser's compliance capabilities that support the fund's fair value processes, and the oversight and financial resources made available to the CCO relating to fair value.

Boards should also consider the type, content, and frequency of the reports they receive. The proposed rule would require reporting to the board (both periodically and promptly) regarding many aspects of the adviser's fair value determination process as a means of facilitating the board's oversight as discussed below. While a board can reasonably rely on the information provided to it in summaries and other materials provided by the adviser and other service providers in conducting its oversight, it is incumbent on the board to request and review such information as may be necessary to be fully informed of the adviser's process for determining the fair value of fund investments. Further, if the board becomes aware of material matters (whether the board identifies the matter itself or the fund's CCO or adviser or another party identifies the issue), we believe that in fulfilling its oversight duty the board must inquire about such matters and take reasonable steps to see that they are addressed.^[94]

We request comment on this aspect of the proposal:

19. Should we permit boards to fulfill the statutory function to fair value one or more fund investments in good faith by assigning that fair value determination to an adviser to the fund as described above? Would the proposed rule change the services provided by advisers with respect to valuation and, if so, would such a change have any implications for the board's consideration of the advisory contract under section 15(c) of the Act (e.g., changes in compensation)? If so, are there additional responsibilities under the proposed rule for which advisers would seek additional compensation?

20. The rule would permit boards to assign the determination of fair value only to an adviser to the fund. Are there other parties to which we should permit boards to assign such determinations? For example, would it be appropriate to allow boards to assign these determinations to pricing vendors or accounting firms? Are there any parties that fund boards currently rely upon to help make fair value determinations that could adequately be relied upon in the same way as a fund adviser? If we do permit other parties to be assigned the determination of fair value under the final rule, what safeguards, if any, should we include to ensure that the determinations of fair value in good faith are conducted consistent with the proposed rule? For example, should we only permit assignment to non-advisers if they have a fiduciary duty to the fund or if they are regulated by the Commission? Why or why not?

21. As proposed, the rule would require that an assignment to an investment adviser cover all elements of paragraph (a) for a given investment or investments. Should we permit the assignment of particular elements of paragraph (a) to an investment adviser or different advisers? If so, what safeguards should we include to ensure that the determinations of fair value in good faith are conducted consistent with the proposed rule?

22. The proposed rule would permit boards to assign the determination of fair value in good faith to the fund's primary investment adviser or one or more sub-advisers. Should we allow boards to assign this process to sub-advisers, or only allow the fund's primary investment adviser to fulfill this role? Why or why not? Should we impose any obligations for the adviser to oversee any assigned sub-adviser? If so, what obligations? For example, should we require in the rule that a fund must establish reconciliation procedures to address situations where sub-advisers have differing views on the fair value of a fund investment?

23. Should we limit the assignment to a single adviser in order to minimize the issues relating to having multiple advisers assigned determinations of fair value under the Act? If so, why? Conversely, should we require additional safeguards in the case of multiple assigned advisers? If so, what should they be? For example, should we require specific policies and procedures or reports, beyond those already required, or those that would be required, under rule 38a-1 or the proposed rule?

24. Should we permit or require anyone other than the trustee of a UIT to perform the functions described in paragraph (a), such as a person appointed by the trustee? Should we, for example, allow the trustee to assign these determinations to the UIT's sponsor, principal underwriter, or depositor? Would these or any other parties be better equipped to determine the fair value of investments? If the rule were to permit the trustee to assign these determinations to another person, should we require that person to report to the trustee like the adviser would to a board for management companies? What kind of oversight responsibilities should the trustee have? Are there other modifications to the proposed rule that we should make to apply it to UITs given their unmanaged nature and different governance structure compared to other funds?

25. Is our proposed requirement that a board “oversee” the adviser sufficient? Should we prescribe in rule 2a-5 additional steps to mitigate the risk of conflicts of interest and other issues related to the fair value process, such as a third party review of the fair value process, or an attestation by the adviser? If so, what should those steps be? What additional costs would they add, and who would bear those costs?

26. As noted above,^[95] the proposed rule would define “board” as either the fund's entire board of directors or a designated committee of such board composed of a majority of directors who are not interested persons of the fund.^[96] Are there any actions required in the proposed rule that we should require the full board, rather than a committee, to perform?

27. Would boards assign the fair value determination to an investment adviser with respect to some investments and determine the fair value of other investments themselves? If so, what types of investments would boards most likely assign to an adviser and under what circumstances, and which would they fair value themselves? Should we provide any additional guidance as to how boards would determine the fair value of fund investments where the board does not assign those determinations to an adviser?

2. Board Reporting

Effective information flow is a critical part of a board's oversight of an adviser to whom it has assigned fair value determinations. We understand that boards currently receive a variety of reports from the adviser outlining the operation of the fund's valuation process.^[97] While some of the reports currently provided may be useful for boards, others may contain detailed trade-by-trade information, or other day-to day operational data that may not be effective in facilitating the board's oversight. We believe that it is important for the board to receive relevant and tailored information from the adviser to ensure that the board has sufficient insight and data to exercise the oversight contemplated by the proposed rule. We also believe that these reports should familiarize directors with the salient features of the adviser's process and provide them with an understanding of how that process addresses the requirements of rule 2a-5. Therefore we are proposing the board reporting requirements discussed below.^[98] These requirements are intended to help ensure that boards receive the amount and type of information that they find most valuable in overseeing the adviser.^[99]

The proposed rule would require the adviser's reports to include such information as may be reasonably necessary for the board to evaluate the matters covered in the reports.^[100] This requirement is designed to provide the fund's board with sufficient context for the matters covered in the report. This context is necessary in order to facilitate the board's oversight by providing them with enough information to determine whether to ask additional questions or request additional information, as appropriate. For example, we do not believe that it would be consistent with the proposed rule for the adviser to report that there is a new material conflict of interest without the context necessary for the board to evaluate what effect the conflict would have on the adequacy and effectiveness of the adviser's process for determining fair value. The content of the periodic or prompt reports and supplemental information under the proposal could take the form of narrative summaries, graphical representations, statistical analyses, dashboards, or exceptions-based reporting, among other methods.

a. Periodic Reporting

Proposed rule 2a-5 would require the adviser, at least quarterly, to provide the board a written assessment of the adequacy and effectiveness of the adviser's process for determining the fair value of the assigned portfolio of investments.^[101] We understand that the materials currently prepared for boards for purposes of board meetings can include detailed information regarding the fair value process, including a list of each individual portfolio holding that received a fair value since the prior board meeting (e.g., during the quarter).^[102] Although some boards may find this specific information useful, we are not proposing to mandate this level of detailed reporting because we believe that the board's oversight may be better facilitated through the use of more targeted forms of reporting designed to identify trends, exceptions, or outliers, and generally provide a sufficient overview of the current state of the fair value process.^[103] Accordingly, the proposed rule would require the adviser's periodic reports to provide the adviser's evaluation of the adequacy and effectiveness of its process for determining fair value. The periodic reports would be required to, at a minimum, include a summary or description of the following information:

• Material Valuation Risks. The assessment and management of material valuation risks that would be required under the proposed rule. This would include any material conflicts of interest of the investment adviser and any other service provider.^[104] As discussed above, we believe that assessing and managing identified valuation risks is an important element for determining fair value in good faith because valuation risks that are not effectively managed can make it more likely that the adviser has incorrectly valued an investment.

• Material Changes to or Material Deviations from Methodologies. Any material changes to, or material deviations from, the fair value methodologies established under the proposed rule.^[105] This requirement would keep boards informed of such changes or deviations, which may show that the methodologies need to be updated or adjusted, and provide an opportunity for a board to ask questions regarding the reasons for any change or deviation.

• Testing Results. The results of any testing of fair value methodologies as part of the required fair value policies and procedures.^[106] As discussed above, the requirement to test the appropriateness and accuracy of the methodologies used to calculate fair value is designed to help ensure that the selected fair value methodologies are appropriate and that adjustments to the methodologies are made where necessary.

• Resources. The adequacy of resources allocated to the process for determining the fair value of the fund's assigned investments, including any material changes to the roles or functions of the persons responsible for determining the fair value.^[107] The adviser's assessment of the adequacy of these resources may inform a board in determining the level of scrutiny to apply in overseeing an adviser's fair value determinations.

• Pricing Services. Any material changes to the adviser's process for overseeing pricing services,^[108] as well as any material events related to its oversight of such services, such as changes of service providers used or price overrides.^[109] This information is designed to help the board oversee the adviser's use of pricing services, if applicable, and to help ensure that pricing information received from service providers serves as a reliable input for determining fair value in good faith.

• Other Requested Information. Any other materials requested by the board related to the adviser's process for determining the fair value of fund investments.^[110]

These requirements collectively are designed to help ensure that boards obtain the information that they need to exercise their statutory and fiduciary duties and to oversee an adviser. They are intended to supplement, not replace, this oversight. Boards should critically review the information provided to them, particularly with regard to an adviser's reporting on its own conflicts of interest, and request any information that they feel is necessary to conduct that oversight. For example, in addition to the specific items listed above,^[111] a board could review and consider, if relevant:

• Summaries of adviser price challenges to pricing information provided by third-party vendors and of price overrides, including back-testing results related to the use of price challenges and overrides;
• Specific calibration and back-testing data, including in the case of back-testing whether fair value prices moved in the same direction (relative to the prior market prices) as the portfolio holdings' next actual market prices, whether fair value prices were closer to the portfolio holdings' next actual market prices than the prior market prices (regardless of the direction), and whether the difference between the fair value prices and the subsequent prices was greater than pre-established tolerance levels; ^[112]

• Reports regarding portfolio holdings for which there has been no change in price or for which investments have been held at cost for an extended period of time (“stale prices”);
• Reports regarding portfolio holdings whose price has changed outside of predetermined ranges over a set period of time;
• Narrative summaries or reports on pricing errors, including the date of any error, the cause, the impact on the fund's NAV, and any remedial actions taken in response to the error;
• Reports on the adviser's due diligence of pricing services used by the fund;
• The results of testing by the fund's independent auditor provided to the audit committee;
• Reports analyzing trends in the number of the fund's portfolio holdings that received a fair value, as well as the percent of the fund's assets that received a fair value; and
• Reports on the number and materiality of securities whose fair values were determined based on information provided by broker-dealers; the broker-dealers most frequently used for this purpose; and the results of back-testing on the information they provided.

We request comment on our proposed requirement that advisers periodically provide a written evaluation of the adequacy and effectiveness of the adviser's process for determining the fair value of the assigned portfolio of investments, including, at a minimum, certain specified summaries or descriptions.

28. Is the proposed periodic reporting requirement appropriate? What resources would be required for an adviser to provide the required quarterly assessment of the adequacy and effectiveness of the adviser's process? Are there additional or different matters that we should require advisers to address in the periodic reports? Are there some items that we should not require? If so, which, and why?

29. Should we require a different minimum reporting frequency for periodic reports? Should we, for example, require advisers to provide these reports monthly or in connection with each regularly scheduled board meeting? Should we require some or all of the specified information to be provided less frequently, such as annually?

30. Is what should be included in an assessment clear? Should we include additional guidance to explain what this entails? Are the other key terms used in the proposal, such as “assess,” and “material” sufficiently understood or is further guidance advisable for those terms? Should they be defined in the rule, and, if so, how? Should the rule use different terms, and, if so, which terms?

31. Are there circumstances in which boards should receive specific information on each individual portfolio holding that received a fair value during the quarter or certain such holdings?

32. We are proposing to require that all price overrides be reported as supplemental information to the board as part of the periodic report. Should we limit which price overrides must be reported, and, if so, how? Alternatively or in addition, should we require reporting regarding all price challenges, even those that do not lead to overrides?

33. Is there additional specific information that we should require to be part of these periodic reports? Are there any other reports that some boards currently receive that should be required under the proposed rule?

34. In light of their importance, should the rule impose specific requirements beyond reporting regarding pricing services? For example, should any pricing services used be explicitly approved by the board? Should there be a required finding or report by the adviser as to pricing services' adequacy and effectiveness?

b. Prompt Board Reporting

We also believe that it is important for the adviser to notify the board of certain issues as they arise that may require their immediate attention. Proposed rule 2a-5 would require that the adviser promptly report to the board in writing on matters associated with the adviser's process that materially affect, or could have materially affected, the fair value of the assigned portfolio of investments, including a significant deficiency or a material weakness in the design or implementation of the adviser's fair value determination process or material changes ^[113] in the fund's valuation risks.^[114] These reports, like the periodic reports discussed above, also must include such information as may be reasonably necessary for the board to evaluate the matter covered in the report.

“Could have materially affected” is intended to capture certain circumstances where, for example, a matter was detected which affected one security and which may not be material on its own, but, had the matter not been identified, could have materially affected the larger assigned portfolio of investments or some subset of that portfolio.^[115] This concept is not intended to mandate reporting in circumstances where, at the time the matter was detected, it did not seem that the matter would materially affect the fair value of the assigned portfolio but the matter later ended up having such an effect.

We are proposing to require the adviser to provide these reports promptly, but in no event later than three business days after the adviser becomes aware of the matter, rather than waiting until the next periodic report.^[116] We believe it is appropriate that the board receive prompt reports regarding matters that materially affect fair value determinations because the proposed rule would allow the board to assign to an adviser fair value determinations otherwise allocated to the board under the Act, and there may arise an issue of such importance that requires prompt board attention. We recognize that the kind of matters that may require this prompt reporting (i.e., outside of the periodic reports) may vary. Some situations may warrant an immediate report, while in other cases it may be appropriate for the adviser to take some additional time to evaluate how to address the matter before engaging the board. We believe that requiring such a report to be “prompt,” but in no event later than three business days after the adviser becomes aware, balances the need for the board to be timely informed of material valuation issues, while allowing the adviser to evaluate and respond appropriately.

We also understand, however, that there may be some circumstances when an adviser becomes aware of an issue that may affect fair value of the portfolio but that the materiality of a given event may be in question. In such a case, an adviser may need additional time to determine and verify whether an event has or could materially affect the fair value of the portfolio assigned to the adviser. Accordingly, we believe that if an adviser needs some reasonable amount of time after becoming aware of the matter to verify and determine its materiality, that verification period would not be counted as part of the “prompt” trigger period. In general, we believe that this verification and final determination process should be completed within three business days or less, including the day that the adviser became aware of the triggering event. Therefore, any prompt reports generally should occur no more than three business days after the adviser becomes aware of the event, but the adviser may, to the extent necessary, take limited additional time (but in no event more than three business days) for the verification and final determination process.

We request comment on our proposed requirement regarding prompt reporting on certain matters associated with the adviser's process that materially affect, or could have materially affected, the fair value of the assigned portfolio of fund's investments.

35. Are the proposed prompt reporting requirements appropriate? Are there additional or different matters that we should require advisers to address in their prompt reports?

36. Should the trigger for prompt reporting be tied to a specific bright line or instead be dependent on facts and circumstances? For example, instead of the trigger being when the adviser becomes aware of the matter should it instead be when the event occurs? If so, would advisers reasonably be able to know when such events occur such that they could report in a timely fashion? Alternatively, should it be when the adviser determines and verifies the impact of the event regardless of how long it takes after the adviser becomes aware of the matter?

37. Are the standards of “materially affecting” or “could have materially affected” sufficiently understood? Should we provide more context on what these terms mean, specifically as they relate to the context of material weaknesses? Should we instead adopt a different standard, such as one that uses specific triggers, to identify matters for prompt reporting? If so, which triggers? For example, should we instead require reporting when a specific number of price overrides have occurred?

38. Should we identify any other issues that the adviser should report promptly to the board? For example, instead of requiring any changes to the fund's fair value methodologies to be reported during the periodic reports, should we instead require that they also be reported promptly? Alternatively, are there matters that would be required to be reported promptly that should instead be reported as part of the periodic report?

39. Is the specified timeline for prompt reporting appropriate or should we consider different time frames? For example, should we require that an adviser report to the board within 1 or 10 business days? Should the time frame be different for certain types of circumstances? If so, which ones?

40. Will advisers be able to make the appropriate determinations in the limited time discussed above? Will advisers need more than three business days to make such a materiality decision? Is three days too long? Should we specify a time for making materiality decision in the rule?

41. The proposed rule would require all reports to be in writing, including prompt reports. Should we provide that in the case of prompt reports, advisers could make oral reports so long as adequate records are kept?

42. Should we require that, if the report is not made to the full board, the designated board committee make a report to the full board within a specified time frame, such as at the next regularly scheduled meeting?

43. Should we permit the adviser to make prompt reports to a pre-identified individual director? What controls should we require if we did permit this? For example, should that director be required to be one of the independent directors?

3. Specification of Functions

If the board assigns the fair value determination requirements for one or more fund investments to an adviser, the proposed rule would require the adviser to specify the titles of the persons responsible for determining the fair value of the assigned investments, including by specifying the particular functions for which the persons identified are responsible.^[117] If the adviser uses a valuation committee or similar body to assist in the process of determining fair value, the fair value policies and procedures generally should describe the composition and role of the committee, or reference any related committee governance documents as appropriate. In addition, the fair value policies and procedures also should identify the specific personnel with duties associated with price challenges, including those with the authority to override a price, and the roles and responsibilities of such persons, and establish a process for the review of price overrides.^[118]

In addition, the proposed rule would require the adviser to reasonably segregate the process of making fair value determinations from the portfolio management of the fund.^[119] One significant source of potential adviser conflicts of interest in the fair value determination process is the level and kinds of input that fund portfolio managers or persons in related functions have in the design or modification of fair value methodologies, or in the calculation of specific fair values.^[120] In many circumstances, the fund's portfolio manager may be the most knowledgeable person at an investment adviser regarding a fund's portfolio holdings. For this reason, it may be appropriate for portfolio managers to provide input into the process for determining the fair value of fund investments. On the other hand, because portfolio management personnel are often compensated in part based on the returns of the fund, a portfolio manager's incentives may not be fully aligned with the fund's with respect to determination of fair value, and a portfolio manager therefore should not be making the fair value determinations.^[121]

Further, we believe that a fund generally should consider the extent of influence portfolio managers may have on administration of the fair value process, and seek to provide independent voices and administration of the process as a check on any potential conflicts of interest to the extent appropriate.^[122] Separation of functions facilitates these important checks and balances, and funds could institute this proposed requirement through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel. The proposed rule would require reasonable segregation of functions, rather than taking a more prescriptive approach, such as requiring funds to implement strict protocols regarding communications between specific personnel, to allow funds to structure their fair value determination process and portfolio management functions in ways that are tailored to each fund's facts and circumstances, including the size and resources of the fund's adviser. In this regard, the reasonable segregation requirement is not meant to indicate that portfolio management must necessarily be subject to a communications “firewall.” We recognize the important perspective and insight regarding the value of fund holdings that portfolio management personnel can provide. Accordingly, this segregation requirement would not prevent portfolio managers from providing inputs that are used in the fair value determination process, as noted above. Instead, this reasonable segregation requirement is designed to help reduce and manage potential conflicts of interest. Keeping the functions reasonably segregated in the context of fair value determinations should help mitigate the possibility that these competing incentives diminish the effectiveness of fair value determinations.

We request comment on this proposed requirement.

44. Should the rule require assigned advisers to reasonably segregate the process of making fair value determinations from the portfolio management of the fund? Would this pose any difficulty for particular types of entities, for example funds managed by small advisers?

45. Is there a better way to prevent conflicts between a portfolio manager's incentives and a fund's interest, for example, in determination of investment values that do not result in dilution of purchasing or redeeming investors? Should we provide any additional clarification regarding the proposed reasonable segregation requirement? If so, what changes should we make? Should we add or change any specific requirements? For example, should we prohibit portfolio management from having any involvement in the fair value process or should we generally prohibit their involvement outside of certain situations beyond making fair value determinations? If so, what level of involvement should we permit? Further, should we exempt smaller advisers from this requirement or clarify that this is a key risk and thus, where feasible, such personnel should be segregated, without making segregation an explicit regulatory requirement? Are there effective steps, other than segregation, that funds currently use to manage the potential conflicts of portfolio management personnel that the rule should require instead of segregation? If so, what are they and why should they be required instead?

4. Records of Assignment

Under the proposed rule, in addition to the records that would need to be kept as part of a good faith determination of fair value generally, a fund must also keep records related to the fair value determinations assigned to the adviser. Specifically, the fund would be required to: (1) Keep copies of the reports and other information provided to the board required by the rule and (2) a specified list of the investments or investment types whose fair value determinations have been assigned to the adviser pursuant to the requirements of the proposed rule.^[123] In each case, these records would be required to be kept for at least five years after the end of the fiscal year in which the documents were provided to the board or the investments or investment types were assigned to the adviser, the first two years in an easily accessible place.^[124]

As discussed above, funds must create and retain certain documentation, including the reports that advisers make to the fund board.^[125] Further, we believe that a clear identification of the investments or investment types that the board has assigned to the adviser would facilitate the board's oversight of the adviser's fair value determinations.^[126] These proposed recordkeeping requirements are designed to achieve these objectives and to facilitate compliance, and related regulatory oversight, with the proposed rule.

We request comment on these proposed additional recordkeeping requirements.

46. Are there any additional types of records that we should require the fund to maintain in connection with the assignment process? Why or why not?

47. Should we apply any or all of the proposed recordkeeping requirements of this section to the adviser, rather than the fund? If so, which requirements?

48. Are the holding periods sufficient to evidence compliance? Why or why not? Should they be different (e.g., six years)?

C. Readily Available Market Quotations

The board's role in the valuation of a portfolio holding for purposes of fair value depends on whether or not market quotations are readily available for such a holding. Under section 2(a)(41) of the Investment Company Act, if a market quotation is readily available for a portfolio holding, it must be valued at the market value. Conversely, if market quotations are “not readily available,” the holding's value must be fair value as determined in good faith by the board.^[127]

Neither the Investment Company Act nor the rules thereunder currently define “readily available.” However, we understand that industry practice has developed to incorporate many of the concepts of ASC Topic 820 when evaluating whether market quotations are readily available.^[128]

The proposed rule would provide that a market quotation is readily available for purposes of section 2(a)(41) of the Investment Company Act with respect to an investment only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable.^[129] Fair value, as defined in the Act, therefore must be used in all other circumstances.^[130] As discussed previously, we believe that for a fair value methodology to be appropriate under the proposed rule, it must be determined in accordance with U.S. GAAP. As mentioned above, U.S. GAAP requires funds to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. However, under U.S. GAAP there are circumstances where otherwise relevant observable inputs become unreliable.^[131] Consistent with this, a quote would be considered unreliable under proposed rule 2a-5(c) in the same circumstances where it would require adjustment under U.S. GAAP or where U.S. GAAP would require consideration of additional inputs in determining the value of the security. For example, under current U.S. GAAP, funds looking to the proposed rule would use previous closing prices for securities that principally trade on a closed foreign market to calculate the value of that security, except when an event has occurred since the time the value was established that is likely to have resulted in a change in such value.^[132] In such circumstances, the fund would need to fair value the security.

As we have stated previously, evaluated prices are not, by themselves, readily available market quotations.^[133] In addition, “indications of interest” and “accommodation quotes,” for example, would not be “readily available market quotations” for the purposes of proposed rule 2a-5.^[134]

We request comment on our proposed definition of when market quotations are readily available for purposes of section 2(a)(41) and rule 2a-4.

49. Is the proposed definition of when market quotations are readily available under the Investment Company Act appropriate? Should we look elsewhere than or in addition to ASC Topic 820?

50. How should we address investments in pooled vehicles, such as registered investment companies, that are valued at NAV, not at a market price? Do funds currently treat such investments as securities that are fair valued? What would be the burdens on boards of funds that invest substantially in such vehicles (e.g., funds of funds)? To the extent that a board assigned the determination of fair values of such investments to a fund's adviser, would the adviser's use of NAV involve the conflicts of interest or other concerns underlying paragraph (b) of the proposed rule?

51. Would this provision cause any compliance issues with other elements of the proposed rule, ASC Topic 820, or any other provision of the federal securities laws?

52. This definition is designed to track concepts in U.S. GAAP. Should we instead expressly refer to U.S. GAAP in the rule text to ensure that consistency with U.S GAAP in case of changes over time? For example, should the rule instead provide that “market quotations are readily available for purposes of section 2(a)(41) of the Act with respect to an investment only when the investment's value is determined under generally accepted accounting principles of the United States based solely on quoted, unadjusted prices in active markets for identical investments that the fund can access at the measurement date?”

53. Should the Commission define readily available market quotations via rulemaking as proposed, or should we instead provide interpretive guidance?

54. Do practitioners understand what it means in this context for the fund to have access to identical investments at the measurement date? Should some other standard be used, such as “readily access” or “reasonably access”?

D. Rescission of Prior Commission Releases

In ASR 113 and ASR 118, the Commission provided specific guidance for funds regarding the “inclusion” (or recognition), “valuation” (or measurement), and disclosure of investment securities.^[135] Since the Commission issued that guidance, we believe that developments in the FASB accounting standards have modernized the approach to accounting topics addressed in ASR 113 and ASR 118. Further, as noted above, market and fund investment practices have evolved considerably.^[136] As a result, the fund-specific accounting guidance for recognition, measurement, and disclosure provided in those statements may no longer be necessary.

Several examples illustrate how FASB accounting standards have addressed the topics covered in the ASRs. First, ASR 118 provides guidance related to the “inclusion,” or recognition, of securities in a portfolio. Today, U.S. GAAP provides authoritative standards applicable to the recognition of investments by investment companies for financial reporting purposes.^[137] For example, ASC Topic 946: Financial Services—Investment Companies (“ASC Topic 946”) requires that an investment company recognize security purchases and sales as of the date on which the investment company agrees to purchase or sell the investment.^[138] It also provides that securities acquired in private placements and tender offers are required to be recognized as of the date the investment company obtained legal rights and obligations relating to the transferred securities.^[139]

In addition, ASRs 113 and 118 provide guidance related to the valuation and disclosure of securities for financial reporting purposes. Again, U.S. GAAP provides authoritative standards applicable to the measurement of fund investments and related disclosures for financial reporting purposes. For example, ASC Topic 946 requires that investment companies measure investments in debt and equity securities, as well as other investments, at fair value.^[140] ASC Topic 820, in turn, defines “fair value” as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” ^[141] ASC Topic 820 also provides a framework for measuring fair value as well as principles for financial statement disclosures.^[142]

The Commission historically has recognized FASB pronouncements as authoritative for financial reporting purposes in the absence of any contrary Commission determination.^[143] In Financial Reporting Release No. 70,^[144] the Commission stated its determination that the FASB and its parent organization, the Financial Accounting Foundation, satisfied the criteria in section 19(b) of the Securities Act and, accordingly, FASB financial accounting and reporting standards are recognized as “generally accepted” under the federal securities laws.^[145] As a result, registrants are required to comply with those standards for recognition, measurement and disclosure in preparing financial statements filed with the Commission, unless the Commission provides otherwise.^[146] Accordingly, we believe ASR 113 and ASR 118 are not necessary to clarify fund obligations with respect to these accounting topics. We further believe that, because the guidance contained in ASR 113 and ASR 118, on the one hand, and U.S. GAAP, on the other, require funds to reach similar results with respect to the recognition, measurement, and disclosure of fund portfolio holdings, such guidance is not necessary to supplement the requirements of U.S. GAAP. We believe that the measurement concepts under ASC Topic 820 are consistent with the Investment Company Act and the Commission's prior statements that fair value is the amount that an owner of a portfolio holding might reasonably expect to receive upon its “current sale.” ^[147] As a result, we propose to rescind the Commission's prior guidance in ASR 113 and ASR 118.^[148] Additionally, in light of the Sarbanes-Oxley Act giving the PCAOB the authority to establish or adopt professional standards for auditors, subsequent to the release of the Commission guidance in ASR 118, we no longer believe that it is necessary to retain the specific requirement in ASR 118 for an independent accountant of a fund to verify all quotations for securities with readily available market quotations at the balance sheet date. Accordingly, we are proposing to rescind ASR 118, including this specific requirement.^[149]

In addition to the discussions in ASR 113 and ASR 118 regarding accounting, auditing, and the role of the board in determining fair value, these releases also discuss other matters. Because we believe that many of these statements would be superseded by the rule we are proposing here, or have also been superseded by subsequent requirements under U.S. GAAP, we propose to rescind ASR 113 and ASR 118 in their entirety.^[150] We continue to believe that the improper valuation of fund investments that materially affects the NAV of the shares being offered or, in the case of an open-end fund, redeemed, could violate the anti-fraud provisions of the federal securities laws.^[151]

We do not propose to modify the Commission's prior guidance regarding the use of the amortized cost method because the Commission recently considered this topic in the 2014 Money Market Fund Release, and we do not believe that further guidance in this area is required at this time.^[152]

55. Do commenters agree that all of the guidance provided in ASR 113 and ASR 118 has been rendered unnecessary by subsequent developments, including developments in the fund industry, subsequent Commission statements, rulemakings, and developments related to U.S. GAAP, and the requirements of the proposed rule, if adopted? Is there any guidance contained in either of ASR 113 and ASR 118, accounting or otherwise, that commenters believe it is necessary or desirable to retain?

56. To the extent prior guidance has not already been incorporated into U.S. GAAP, is there any prior guidance that should be recommended for incorporation into U.S. GAAP by the FASB?

57. We have previously stated that fair value is what “the owner might reasonably expect to receive . . . upon [a] current sale.” ^[153] Are the concepts of “current sale” in ASR 118 and “exit price” in U.S. GAAP identical? If not, what are the differences between the two standards and how should we address such gap?

58. The proposal does not address the views the Commission has expressed related to the use of amortized cost in valuing portfolio securities with maturity dates of 60 days or less.^[154] Is there other valuation guidance that the proposal should address? Do funds or advisers look to any other guidance on valuation that would be relevant for the Commission to address?

59. Our proposal to rescind ASR 118 would eliminate the Commission's statement in that release regarding verification by an independent accountant of all quotations for securities with readily available market quotations at the balance sheet date. Should we maintain that position regarding independent verification of quotations for all securities for which market quotations are available? What are the benefits or costs associated with independent verification of quotations for all portfolio investments?

60. Is there any other Commission valuation rule (such as rule 6.02(b) of Regulation S-X) or guidance that we should consider rescinding or amending in light of the proposal? If so, why?

E. Existing Staff No-Action Letters, Other Staff Guidance, and Proposed Transition Period

In addition to the proposal to rescind ASR 113 and ASR 118, certain staff letters and other staff guidance addressing a board's determination of fair value and other matters covered by proposed rule 2a-5 would be withdrawn or rescinded in connection with any adoption of this proposal. Upon the adoption of any final rule, some letters and other guidance, or portions thereof, would be moot, superseded, or otherwise inconsistent with the final rule and, therefore, would be withdrawn or rescinded. If commenters believe that additional letters or other guidance, or portions thereof, should be withdrawn or rescinded, they should identify the letter or guidance, state why it is relevant to the proposed rule, how it or any specific portion thereof should be treated, and the reason therefor. Based on the proposed rule, staff letters and guidance that would be withdrawn or rescinded would include, but would not necessarily be limited to, all of the staff letters and other staff guidance listed below.

We also are proposing a one-year transition period to provide time for funds and their advisers to prepare to come into compliance with proposed rule 2a-5. Accordingly, we propose that the effective date of any adoption of this proposal would be one year following the publication of the final rule in the Federal Register. We propose to rescind ASR 113 and 118 at that time, and the identified guidance would be withdrawn.

We request comment on the proposed rescissions and transition period.

61. Are there any other staff letters or guidance pieces that should be rescinded or withdrawn should proposed rule 2a-5 be adopted?

62. Alternatively, should the Commission codify any staff letters or other staff guidance pieces, for example, FAQ 2 in the 2014 Valuation Guidance Frequently Asked Questions? If so, commenters should identify the positions and explain why commenters believe they should be codified.

63. Do commenters agree that a one-year transition period to provide time for funds and their advisers to prepare to come into compliance with proposed rule 2a-5 is appropriate? Should the period be shorter or longer?

64. Should the transition period be the same for all funds that would be subject to proposed rule 2a-5, as proposed? Alternatively, should we adopt tiered transition periods for smaller entities? For example, should we provide an additional six months in the transition period for smaller entities (or some other shorter or longer period)?

65. Instead of a fixed transition period of one year, should we tie the transition period to the fiscal year end of funds? For example, should the transition period instead start for each fund at the beginning of its fiscal year end after the one-year period following adoption of any rule?

III. Economic Analysis

A. Introduction

The proposed rule would provide requirements for determining fair value in good faith for purposes of section 2(a)(41) of the Act and rule 2a-4 thereunder. This determination would involve assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; evaluating any pricing services used; adopting and implementing certain written policies and procedures; and maintaining certain records.^[155] The proposed rule would permit a fund's board of directors to assign the fair value determination relating to any or all fund investments to an investment adviser of the fund, which would carry out all of the functions required under the rule, subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability to effectively oversee the adviser's fair value determinations.^[156] Finally, the proposed rule would define when market quotations are readily available for purposes of section 2(a)(41) of the Act.^[157] We are sensitive to the economic effects that may result from the proposed rule, including the benefits, costs, and the effects on efficiency, competition, and capital formation.^[158] Section 2(c) of the Investment Company Act requires us, when engaging in rulemaking that requires us to consider or determine whether an action is consistent with the public interest, to also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.

The proposed rule would provide a consistent framework for boards to comply with their obligations under section 2(a)(41) of the Investment Company Act and would permit boards to assign fair value determinations to an investment adviser, which would carry out all of the functions required under the proposed rule, subject to oversight and other conditions. Permitting a fund's board to assign fair value determinations to an investment adviser recognizes the developments discussed in Section I above, including the increased complexity of many fund portfolios and the in-depth expertise needed to accurately fair value such complex investments. The proposed rule also recognizes the important role that fund investment advisers now play and the expertise they provide in the fair value determination process given market and regulatory developments over the past fifty years. Permitting a fund's board to assign fair value determinations to the adviser would allow the board to focus its time and attention on other matters related to the fund, such as the oversight of the investment adviser. This could lead to a more efficient use of boards' resources and therefore improve funds' governance for the benefit of fund investors. The proposed rule would impose one-time costs to funds to review the proposed rule's requirements and modify their fair value practices, policies and procedures, reporting, and recordkeeping to comply with the proposed rule. Further, to the extent that fair value determinations would be assigned to a fund's investment adviser, the investment adviser may have to incur ongoing costs to satisfy the new fair value obligations. The investment adviser ultimately may pass through some of these ongoing costs to funds and their investors.

We discuss the potential effects of the proposed rule as well as possible alternatives to the proposed rule in more detail below. Where possible, we have attempted to quantify the costs, benefits, and effects on efficiency, competition, and capital formation expected to result from the proposed rule. In some cases, however, we are unable to quantify the economic effects because we lack the information necessary to provide a reliable estimate. Where we are unable to quantify the economic effects of the proposed rule, we provide a qualitative assessment of the potential effects and encourage commenters to provide data and information that would help quantify the benefits, costs, and the potential impacts of the proposed rule on efficiency, competition, and capital formation.

B. Economic Baseline

1. Current Regulatory Framework

To understand the effects of the proposed rule, we compare the proposed rule's requirements to the current regulatory framework and current industry practices. As discussed in greater detail in Section I above, the regulatory framework regarding fair value determinations and the role of the board of directors in the determination of fair value is set forth in the Investment Company Act and the rules thereunder. The Commission has also expressed its views on the role of the board regarding fair value under the Investment Company Act in several releases, including ASR 113 and ASR 118, the 2014 Money Market Fund Release, and the Compliance Rules Adopting Release.^[159]

Section 2(a)(41) of the Investment Company Act defines the value of assets for which market quotations are not readily available as fair value as determined by the board of directors in good faith. As discussed above, the Commission acknowledged in ASR 113 and ASR 118 that the board need not itself perform each of the specific tasks required to calculate fair value in order to perform its role under section 2(a)(41). However, ASR 113 and ASR 118 stated that the board should choose the methods used to arrive at fair value and continuously review the appropriateness of such methods.^[160] In addition, the Commission stated that boards should consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available.^[161] Finally, the Commission stated that whenever technical assistance is requested from individuals who are not directors, the findings of such individuals must be carefully reviewed by the directors in order to satisfy themselves that the resulting valuations are fair.^[162] The 2014 Money Market Fund Release stated that funds “may consider evaluated prices from third-party pricing services, which may take into account these inputs as well as prices quoted from dealers that make markets in these instruments and financial models.” ^[163] The 2014 Money Market Fund Release also stated that “evaluated prices provided by pricing services are not, by themselves, `readily available' market quotations or fair values `as determined in good faith by the board of directors' as required under the Investment Company Act.” ^[164] In addition, the Commission discussed in that release the factors that the fund's board of directors may want to consider “before deciding to use evaluated prices from a pricing service to assist it in determining the fair values of a fund's portfolio securities.” ^[165]

Finally, the Compliance Rules Adopting Release stated the Commission's view that rule 38a-1 requires compliance policies and procedures with respect to fair value.^[166]

2. Current Practices

Our understanding of boards' current fair value practices is based on fund disclosures, staff discussions with industry representatives, staff's experience, and review of relevant industry publications and academic papers.^[167] We expect that fund's policies and procedures generally reflect their fair value practices.^[168] We discuss below our understanding of current practices but acknowledge that practices may vary across funds and through time. We lack detailed data on the fair value practices of each individual fund and fund board, but, based on available inputs, we preliminarily believe that many of the requirements of the proposed rule are generally similar to current practice. We request data and other information on current fund practices in Section III.E below.^[169]

Fair Value Calculation. Most fund boards do not play a day-to-day role in the pricing of fund investments.^[170] Typically, an investment adviser to the fund or other service providers perform the actual day-to-day fair value calculations.^[171] In addition to performing day-to-day calculations, investment advisers also typically assist the board in developing the fund's fair value methodologies.^[172]

Fair Value Practices—Assess and manage risks. It is our understanding that boards play an important role in identifying and managing the fund's valuation risks.^[173] Examples of valuation risks that funds often address include changes in market liquidity, reliance on a single source for pricing data, reliability of data obtained from pricing services for securities that are not traded on exchanges, reliability of data provided by credit rating agencies, use of internal information provided by portfolio managers to estimate fair values, use of internally developed models to value securities, extensive use of matrix pricing, the process surrounding the adviser's price overrides, timely identification of material events, and valuation risks arising from new investments.^[174] Funds' valuation practices generally focus on mitigating potential conflicts of interest of the investment adviser as well as conflicts of interest of other parties that assist the board with fair value determinations (e.g., portfolio managers).^[175] In particular, some investment advisers currently have in place processes to address potential conflicts of interest when portfolio management personnel provides input regarding valuation for a fund.^[176]

Valuation risks can change with changes in market conditions and changes in fund investments. Hence, funds may periodically review any previously-identified valuation risks.^[177] Some boards meet with the fund's chief risk officer or members of the risk committee on a periodic basis to discuss the valuation of the portfolio securities as part of the assessment and management of previously identified risks.^[178]

Fair Value Practices—Establish fair value methodologies. Further, it is our understanding that funds that invest in securities that are fair valued have in place written policies and procedures that detail the methodologies used when calculating fair values.^[179] The methodologies often establish a suggested ranking of the pricing sources that an adviser should use when valuing securities, and different rankings can be established for different types of securities.^[180] Many funds periodically review the appropriateness and accuracy of the methodologies used in valuing securities and make any necessary adjustments.^[181] Further, funds generally monitor the circumstances that may necessitate the use of fair values.^[182] For example, many funds establish triggering mechanisms in their policies and procedures to monitor circumstances that require the use of fair value methodologies, and third-party pricing services may be used to identify those triggering events.^[183]

Fair Value Practices—Test fair value methodologies. We understand that funds generally test the appropriateness and accuracy of the internally selected methodologies used to value securities. Funds may utilize methods such as back-testing to review the appropriateness and accuracy of the methodologies used.^[184] We understand that many funds use systems to identify security valuations that may require additional attention, such as security prices that have not changed over a period of time and changes in prices beyond a certain threshold.^[185]

Fair Value Practices—Identify responsibilities. Based on our understanding of current industry practices, we believe that funds generally allocate fair value functions,^[186] which may be reflected in a written charter or the fund's valuation policies and procedures.^[187] As discussed above, an investment adviser to the fund assists the board with the day-to-day fair-value process. This allocation of valuation functions can help boards understand and monitor the level of involvement of portfolio managers in the valuation process. Portfolio managers can provide valuable inputs to the valuation of fund securities, but they are subject to conflicts of interest. Some boards create separate valuation committees with clearly established functions that help the board provide oversight of the investment advisers' valuation practices.^[188] If used, the structure of the valuation committees can differ across funds. Finally, fund policies and procedures may include “escalation procedures” that describe the circumstances under which certain investment adviser personnel or board members should be notified when fair value issues arise that are not addressed in existing fair value policies and procedures.^[189]

Fair Value Practices—Evaluate Pricing Services. We understand that funds frequently use third-party pricing service providers to assist in determining fair values.^[190] Before engaging a pricing service, boards may review background information on the vendor, such as the vendor's operations and internal testing procedures, emergency business continuity plans, and methodologies and information used to form its recommended valuations.^[191] Boards may develop an understanding of the circumstances in which third-party pricing services would provide assistance in securities valuation.^[192] In reviewing the performance of these pricing services, boards also may seek input from the fund's adviser or the pricing service itself, including probing whether the investment adviser performed adequate due diligence when selecting the service.^[193] In particular, boards may consider whether the adviser tests prices received from pricing services against subsequent sales or open prices, whether the pricing services are periodically reviewed, and to what extent the pricing service considers adviser input. Funds may establish procedures for ongoing monitoring of the pricing services—including pricing service's presentations to the board, investment adviser's due diligence, and on-site visits to the pricing service—to determine whether the pricing service continues to have competence in valuing particular securities and maintains an adequate control environment.^[194] Further, boards may seek to understand the circumstances under which the adviser may override the prices obtained by the pricing service provider.^[195]

Board Reporting. As part of their current fair value practices, boards may review on a periodic basis reports regarding the fair value of fund securities.^[196] Many boards review fair value determinations quarterly but some boards review the determinations more or less frequently depending on the type of fund securities and the market conditions.^[197] Boards also may have ad-hoc discussions on valuation matters outside of their regular meetings.^[198] Boards may consider the information they want in valuation reports, and, in some circumstances, a board member may play an active role in shaping the content of the valuation reports given to the board.^[199] The content of reports the boards receive depends on the type of fund and fund investments.^[200] The type of general information that the boards may receive include a summary of back-testing data and an analysis of the impact of fair values on the fund's NAV.^[201] The reports also may include more specific information about securities that are more difficult to value, such as the fair values assigned to each security, the size of the holding, the effect of the fair value on the fund's NAV, and the rationale for the decision to fair value.^[202] Some board reports may also include security-specific information in cases where investment advisers override prices provided by pricing services.^[203] Finally, some funds also include in board reports the minutes of, or summary memoranda and other written documentation from, valuation committee meetings held during the prior period.^[204]

Valuation reports may vary depending on the volume and complexity of fair value determinations.^[205] For example, some boards require a case-by-case review of each asset that received fair value, whereas other boards require the adviser to provide a report on an asset that was assigned a fair value and this report is intended to provide a sample of the methodology that is used by the investment adviser.^[206]

Recordkeeping. It is our understanding that most funds currently retain records related to fair value determinations as required by section 31 and the rules thereunder of the Investment Company Act. These records generally include identifying information for each portfolio security, data used for pricing, and any other information related to price determinations and fund valuation policies and procedures.

3. Affected Parties

The proposed rule would affect all funds that invest in securities that must be fair valued under the Act, those funds' boards of directors, investment advisers, and investors. Table 1 below presents descriptive statistics for the funds that could be affected by the proposed rule. As of January 2020, there were 13,733 registered investment companies: (i) 12,379 open-end funds; (ii) 666 closed-end funds; (iii) 674 UITs; and (iv) 14 variable annuity separate accounts registered as management companies.^[207] As of the same date, (i) open-end funds held total net assets of $28,184 billion; (ii) closed-end funds held total net assets of $301 billion; (iii) UITs held total net assets of $1,883 billion; and (iv) variable annuity separate accounts registered as management companies held total net assets of $234 billion. As of September 2019, there were 98 BDCs with $64 billion in total net assets.^[208] Not all funds hold investments that must be fair valued under the Act. In addition, for those funds that hold investments that must be fair valued under the Act, the extent of those investments varies. Hence, the proposed rule would affect only a subset of the funds listed in Table 1 below.

To understand the extent of current boards' involvement in the valuation of funds' investments and the extent to which the proposed rule would affect funds' operations, we examine funds' investments under the U.S. GAAP fair value hierarchy.^[209] For purposes of this economic analysis, we treat investments that are valued using Level 1 inputs as investments for which readily available market quotations would be available, and investments valued using Level 2 and 3 inputs as investments that would be fair valued in good faith by the fund's board of directors.^[210] We therefore expect that funds that hold more securities that are measured using Level 2 and 3 inputs would be more affected by the proposed rule than funds that do not invest in these kinds of securities or hold fewer of them.

Table 2 provides descriptive statistics on funds' investments in securities measured based on Levels 1, 2, and 3 inputs using Form N-PORT data as of January 2020.^[211] As Table 2 shows, there are 11,436 funds with $24,338 billion in net assets that filed Form N-PORT.^[212] About 63% of fund assets are valued using Level 1 inputs. Nevertheless, the average percentage of securities valued using Level 1 inputs varies with the type of fund, ranging from 26% for closed-end funds to 99% for ETFs registered as UITs. About 33% of fund assets are valued using Level 2 inputs, and this percentage varies with the type of fund. Only a small percentage of fund assets are valued using Level 3 inputs.^[213]

Finally, untabulated analysis shows that 28% of the funds only report securities valued using Level 1 inputs.^[214] Consequently, we estimate that approximately 9,986 funds could be affected by the proposal, of which 9,501 are not UITs.^[215] Nevertheless, even though the proposed rule would be relevant for all funds with investments valued using non-Level 1 inputs, not all of those funds would have to materially change their practices under the proposed rule. As discussed in more detail below, the effects of the proposed rule would depend on the extent to which funds' current practices differ from the requirements of the proposed rule.

As of January 2020, there were 1,921 investment advisers that provide portfolio management services to funds and these investment advisers managed assets equal to $28,517 billion.^[216]

Finally, as of December 2018, there were 57.2 million U.S. households and 101.6 million individuals owning U.S. registered investment companies that could be affected by the proposed rule.^[217]

C. Benefits and Costs and Effects on Efficiency, Competition, and Capital Formation of Proposed Rule

1. General Economic Considerations

Unbiased and accurate valuation of fund investments is important because it affects the prices at which fund securities are purchased or sold in the secondary market and also affects the prices at which fund securities are purchased or redeemed in the primary market. The valuation of fund securities is also important because it can affect funds' fee and performance calculations, and also can affect funds' compliance with regulatory requirements. Finally, properly valuing a fund's investments is a critical component of the accounting and financial reporting for investment companies.^[218]

Under the Investment Company Act, whenever market quotations are readily available, these market quotations must be used to determine fund asset values.^[219] Whenever market quotations are not readily available, the value must be the fair value of fund holdings as determined by the board in good faith. This fair value determination can involve the use of complex methodologies, multiple data sources, and various assumptions. Today, we understand that, typically, boards determine the methodologies used to fair value fund investments, but rely on the adviser for the day-to-day calculation of fair values.^[220]

Nevertheless, fund investment advisers have conflicts of interest, which could bias the fair value process.^[221] In particular, investment advisers have incentives to inflate fund asset values (or deflate fund liability values) because they typically receive a management fee that is calculated as a percentage of the value of assets under management.^[222] Relatedly, investment advisers have incentives to inflate fund asset values because investors tend to invest more in funds that performed well in recent periods, which would increase assets under management and ultimately increase investment advisers' compensation.^[223] Investment advisers also have incentives to mismeasure fund investments in a way that would result in smooth reported fund performance over time to lower the funds' perceived risk.^[224] Finally, investment advisers may mismeasure fund investments as a result of expending less effort to value assets than the effort required to ensure accurate and unbiased valuations.^[225]

The degree of conflicts of interest may vary across funds. In particular, investment advisers' incentives to misreport fund investments may be more pronounced for funds that face higher competition to attract new investors and for actively managed funds that face higher demands from investors to beat certain benchmarks. Relatedly, investment advisers' incentives to underinvest in effort may be higher for funds whose performance is more difficult to measure and evaluate, and thus investment advisers' performance is also more difficult to measure and evaluate (e.g., funds that hold complex investments).^[226] Boards of directors currently serve as a check on the conflicts of interest of the adviser and the other service providers involved in the calculations of fair values.^[227]

As discussed in Section I above, since ASR 113 and 118 were first issued roughly fifty years ago, funds' investment practices have changed, the regulatory framework under which funds operate has evolved, and there have been significant advances in technology and communication. The proposed rule would provide an updated framework for valuation under the Investment Company Act that is more suitable to current market realities. The proposed rule retains the important safeguard of board oversight of fair value determinations, while making more efficient use of boards' time and expertise and recognizing the important role of fund investment advisers in the fair value determination process.

The proposed rule differs from the current regulatory framework and funds' current practices in the following ways. First, under the current regulatory framework, funds have flexibility to determine their fair value policies and procedures, reporting, and recordkeeping requirements. The proposed rule would differ from the current regulatory framework because it would mandate more specific fair value practices, policies and procedures, reporting, and recordkeeping requirements and those requirements would be explicitly imposed on funds and performed by boards or advisers.^[228] In particular, the proposed rule would prescribe more specific elements that fair value policies and procedures adopted under the rule must address as compared to the current framework under rule 38a-1.^[229] For example, in addition to the fair value policies and procedures that are required pursuant to rule 38a-1, the proposed rule would require the written policies and procedures to be reasonably designed to address, in the context of methodologies, the selection and application of a methodology in a consistent manner, the specification of which methodologies apply to new types of fund investments in which a fund intends to invest, and testing of the appropriateness and accuracy of the selected methodology, including identifying the testing methods and minimum frequency of testing.^[230] In addition, unlike under proposed rule 2a-5, there is currently no requirement regarding the frequency and content of periodic valuation reports and the promptness and content of ad hoc valuation reports the board receives. The proposed rule would require quarterly periodic reporting as well as prompt reporting no later than three business days after the adviser becomes aware of certain matters relevant to fair value. Also, the proposed rule specifies the matters that the adviser must, at a minimum, cover in its periodic reporting to the board. Finally, rule 38a-1 requires the maintenance of records related to the fund's compliance policies and procedures for five years.^[231] The proposed rule would apply the same retention period, but it would require the maintenance of records that are specific to fair value determinations.^[232] Further, the proposed rule would require the adviser to maintain copies of the reports and other information provided to the board under the rule whenever the board assigns the determination of fair value to an investment adviser to the fund.

Second, we understand that funds' current practices regarding their fair value policies and procedures, reporting, and recordkeeping are generally consistent with the requirements of the proposed rule. Nevertheless, there is variation in funds' fair value practices, and the practices of certain funds may be more or less extensive and thorough than the requirements of the proposed rule. Consequently, the proposed rule would impose uniform minimum requirements on all affected funds related to their fair value policies and procedures, reporting, and recordkeeping.

Third, under the current regulatory framework, boards choose the methodologies used to determine the fair value of the funds' investments, continuously review the appropriateness of such methods, consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available, and carefully review the findings of individuals that are not directors whenever technical assistance is requested from those individuals.^[233] In addition, it is our understanding that some boards currently ratify all or some of the fair value calculations of an investment adviser to the fund. Under the proposed rule, boards may assign a fair value determination to an investment adviser of the fund, who would carry out all of those functions.^[234] It is our understanding that funds' investment advisers already assist the board with respect to many of those functions subject to the board's oversight.

Under the proposed rule, fund boards would have discretion to assign the fair value determination to an investment adviser to the fund, who would carry out all of the functions that would be required under the rule. When deciding whether to assign fair value determinations to an investment adviser to the fund, a board would consider certain trade-offs. In particular, fund boards' decisions to oversee investment advisers' fair value determinations instead of determining fair value themselves would depend on the amount of investments that must be fair valued, the nature and complexity of the valuation of those investments, the type of fund, the investment adviser's willingness to assume additional fair value responsibilities, and the fund's current practices. Boards of funds that hold more securities that must be fair valued and harder-to-value securities may be more likely to assign these fair value determinations to an adviser and oversee the process of determining fair value by the assigned adviser because investment advisers may be better suited to value certain investments. It may also depend on the type of fund. For example, a board of an open-end fund that must calculate NAVs on a daily basis may be more likely to assign to an investment adviser the determination of fair values (on which fund's NAV is based) than the board of a fund that calculates value less regularly. The decision to oversee investment advisers' fair value determinations would also depend on investment advisers' willingness to assume the assigned responsibilities. Such willingness would depend on investment advisers' valuation expertise and experience, whether the investment advisers have available resources to satisfy their new obligations, and the extent to which the investment advisers could pass through to the fund and its investors any higher costs associated with the increased responsibilities. Finally, a board's decision to assign responsibilities under the proposed rule would depend on the expected costs of compliance, which would ultimately depend on how different funds' current practices and policies and procedures are from the requirements of the proposed rule.

We lack detailed and representative information on funds' current fair value practices and we do not have visibility into boards' decision-making processes when seeking the investment advisers' assistance with fair value determinations.^[235] Further, boards' decision-making processes with respect to seeking the investment advisers' assistance with fair value determinations is complex. Hence, we are unable to accurately estimate the number of fund boards that would assign responsibilities to an adviser under the proposed rule instead of the boards making fair value determinations in good faith themselves. Nevertheless, we believe that most boards would assign these responsibilities to an investment adviser to the fund because the investment adviser has valuation experience and expertise and is involved with the fund's operations on a daily basis and, thus, may be better suited than the board to deal with fair value matters that arise on a daily basis. Further, advisers already provide significant assistance with the fair value determinations to the board of directors and so funds would not be required to significantly modify their operations if they choose to assign fair value determinations to an investment adviser to the fund under the proposed rule. As a result, for the purpose of our economic analysis, we assume that all funds that have some securities that would need to be fair valued would be affected parties.

We expect that the effects of the proposed rule could differ across funds. In particular, under the proposed rule, if the fund is a unit investment trust, the fund's trustee must carry out the fair value determinations.^[236] Hence, UITs would not bear any costs associated with oversight and reporting. We expect the effects of all other aspects of the rule to be similar for UITs and other funds. Further, the proposed rule would have larger effects on funds that currently do not utilize advisers in the fair value process but would choose under the proposed rule to assign the fair value determination of fund investments to an investment adviser to the fund. In addition, the proposed rule would also have a larger effect on funds for which a larger percentage of their investments do not have readily available market quotations because those funds would be required to determine the fair value of a larger percentage of their investments in compliance with the rule. The proposed rule would also have larger effects on funds whose current fair value policies and procedures, reporting, and recordkeeping requirements differ more from the proposed rule's requirements. The proposed rule could have a larger effect on smaller funds because of economies of scale in the adoption and implementation of the proposed rule's requirements. In particular, as discussed in detail in Section III.C.3 below, there are certain fixed costs associated with the implementation of the proposed rule's requirements, such as testing and preparing methodologies, policies and procedures, and training materials, and those fixed costs would be less burdensome for larger funds, who could spread those costs across a larger amount of assets under management. Finally, whenever the fair value determinations would be assigned to the fund's investment adviser, the requirement to reasonably segregate the investment adviser's process of making fair value determinations from the portfolio management could be more costly for smaller investment advisers than for larger ones. The reason is that smaller investment advisers could lack the staff and resources to segregate portfolio management personnel from those making fair value determinations as efficiently as larger advisers or might only be able to meet this requirement by hiring additional personnel.

We discuss the benefits and costs of the proposed rule as well as the effects on efficiency, competition, and capital formation in detail below.

2. Benefits

The proposed rule would mandate specific fair value functions, including written policies and procedures, reporting, and recordkeeping that funds would have to have in place to comply with the statute, and would define which securities are considered to have readily available market quotations under section 2(a)(41) of the Act. This increased specificity could reduce compliance costs in that funds may expend less effort and time to design policies and procedures, reporting, and recordkeeping under the proposed rule than trying to determine appropriate compliance under the statute alone.^[237] For funds whose current practices are more burdensome than the proposed rule's requirements, this increased specificity also could reduce compliance costs to the extent that funds might be less likely to put in place overly burdensome and unnecessary policies and procedures, reporting, and recordkeeping to comply with the statute.^[238] Relatedly, the proposed rule and the rescission of existing no-action letters and guidance would increase certainty because funds would follow a single rule rather than following various no-action letters and guidance when determining fair values, which could ultimately reduce compliance costs.^[239] Lower costs of compliance for funds ultimately could benefit fund investors to the extent that any cost savings would be passed down to them in the form of lower fund operating expenses.

In addition, the proposed rule would benefit funds and their investors because it would allow boards to allocate more fair value responsibilities to an investment adviser to the fund, and thus could free board resources tied to valuation and redirect them to oversight or other matters in which board action may be more valuable.^[240] In particular, for funds whose boards of directors would assign the fair value determinations to an investment adviser to the fund, the boards would no longer be required to choose the methodologies used to determine the fair value of the funds' investments, continuously review the appropriateness of such methods, consider all appropriate factors relevant to the fair value of securities for which market quotations are not readily available, and carefully review the findings of individuals that are not directors whenever technical assistance is requested from those individuals. We lack detailed data on boards' current practices and so we are unable to estimate these cost savings but we request comment on this point in Section III.E. below.^[241]

Finally, the proposed rule would require all funds to adopt specific policies and procedures related to fair value determinations. In addition, whenever the board assigns the fair value determination relating to a fund investment to an investment adviser, the proposed rule would require the board's effective oversight of the investment adviser's conflicts of interest related to fair value determinations. To the extent that certain funds' fair value policies and procedures currently are less thorough than the policies and procedures of the proposed rule and certain boards' oversight of the investment advisers' conflicts of interest is less effective than under the proposed rule, the proposed rule could decrease the likelihood that fund investments would be inaccurately fair valued.^[242] This is because the proposed rule could create a more robust valuation framework and could help to address any conflicts of interest of the investment adviser, which could result in more accurate and unbiased asset prices. Any such effects likely would be more pronounced for investors of funds that are not publicly traded (e.g., open-end funds and BDCs) because there is no secondary market for the shares of those funds and fund investors can only trade at NAV, which is determined by the fund's fair value determinations. Nevertheless, this may not have a significant effect because it is our understanding that many funds currently have in place fair value practices that are similar to the proposed rule's requirements and boards oversee the investment adviser's assistance with fair value calculations.

3. Costs

The proposed rule would impose one-time costs on funds and their investors.^[243] We expect that funds would incur one-time costs to review the proposed rule's requirements and modify, as necessary, their fair value practices, policies and procedures, and recordkeeping to comply with the proposed rule. Funds whose boards would assign the fair value determinations to the investment adviser would also incur one-time costs to review the proposed rule's requirements and modify their oversight and reporting procedures to comply with the rule. Even though we understand that most funds currently have in place practices related to fair value determinations, those practices differ across funds and also may differ from the proposed rule's requirements. In particular, the types of policies and procedures that funds have in place related to fair value determinations, the frequency and content of periodic board reporting, the promptness and content of ad hoc board reporting, and the extent and duration of recordkeeping may differ under the proposed rule compared to current practices.

Our staff estimates that the one-time incremental costs necessary to ensure compliance with the proposed rule would range from $100,000 to $600,000 per fund, depending on the current fair value practices of the fund.^[244] These estimated costs are attributable to the following activities: (i) Reviewing the proposed rule's requirements; (ii) developing new (or modifying existing) policies and procedures, reporting, and recordkeeping requirements to align with the requirements of the proposed rule; (iii) integrating and implementing those policies and procedures, reporting, and recordkeeping requirements to the rest of the funds' activities; (iv) preparing new training materials and administering training sessions for staff in affected areas; and (v) independent board members consulting their independent counsel on whether fair value determinations should be assigned to the fund's investment adviser and how to set up appropriate policies and procedures, reporting, and recordkeeping requirements. We expect that the one-time incremental cost necessary to ensure compliance with the proposed rule would depend on the fund's current fair value practices and the amount and valuation complexity of fund investments that must be fair valued. In particular, the one-time costs would be closer to the lower end of the range for funds whose current practices are more similar to the requirements of the proposed rule and funds with fewer and easier-to-value fund investments. Further, the one-time costs would be closer to the lower end of the range for funds that belong to fund complexes because certain aspects of the one-time costs are fixed costs that could be spread across multiple funds in the case of fund complexes.

As discussed above, out of the 13,831 funds, we estimate that 9,986 would be affected the proposed rule, and thus incur the one-time costs associated with the proposed rule.^[245] We estimate that 70% of the one-time costs would be attributable to funds reviewing and updating the current practices and related policies and procedures to comply with the proposed rule's requirements; 15% of those costs would be attributable to funds reviewing and updating current recordkeeping processes to align with the proposed rule's requirements; and the remaining 15% of those costs would be attributable to funds reviewing and updating the current board reporting processes to comply with the proposed rule's requirements. Hence, we estimate the aggregate one-time costs of the proposed rule to range between $991.3 million and $5.9 billion.^[246]

For funds whose boards would assign the fair value determinations to the funds' investment advisers, those one-time costs would be borne by the investment adviser, and could be ultimately passed through to the fund shareholders in the form of higher management fees. For funds whose boards determine the fair values themselves, those one-time costs could be ultimately passed through to the fund shareholders in the form of higher operating expenses. We expect that the vast majority of the boards would assign fair value determinations relating to an investment adviser to the fund, and so the majority of the one-time costs would be borne by the fund's investment adviser, and ultimately could be passed through to the fund shareholders in the form of higher management fees.

The proposed rule also could impose ongoing costs on all funds that hold securities without readily available market quotations because those funds would be required to comply with the proposed rule's policies and procedures, reporting, and recordkeeping requirements. Nevertheless, we believe that funds' incremental ongoing costs associated with this aspect of the proposed rule would be limited to the extent that, as discussed in Section III.B.2. above, funds currently have in place practices, policies and procedures, reporting, and recordkeeping associated with fair value determinations that are similar to the proposed rule's requirements. Certain funds might put in place policies and procedures, reporting, and recordkeeping to comply with the proposed rule that are more costly than the funds' current practices, while other funds might set up policies and procedures, reporting, and recordkeeping as a result of the proposed rule that would result in lower ongoing costs than the costs of current practice. We acknowledge that funds whose practices, policies and procedures, reporting, and recordkeeping are less costly than the proposed rule's requirements would bear additional ongoing costs under the proposed rule. We lack detailed data on funds' fair value practices, policies and procedures, reporting, and recordkeeping, and so we are unable to estimate the net incremental ongoing costs of the proposed rule on funds, but we request comment on this topic in Section III.E. below.^[247]

The proposed rule also would mandate more detailed and specific policies and procedures, reporting, and recordkeeping than the current regulatory framework, which could decrease funds' flexibility to design policies and procedures, reporting, and recordkeeping that better meet their preferences. Consequently, funds could bear costs to implement practices (e.g., quarterly periodic reporting) that are incompatible with the way they would approach these matters absent rule 2a-5. Any such costs could be borne ultimately by fund investors in the form of higher operating expenses.

For funds whose boards would assign the fair value determinations to the funds' investment advisers, the proposed rule could impose additional ongoing costs associated with boards' oversight of the investment adviser's fair value determinations and review of board reports. Nevertheless, we believe that funds' incremental ongoing costs associated with this aspect of the proposed rule would be limited to the extent that boards or funds currently have in place policies to ensure appropriate oversight of an investment adviser's assistance with fair value calculations and boards currently review periodic and ad-hoc reports related to fair value determinations prepared by the fund's investment adviser. Hence, we do not believe that this aspect of the proposed rule would impose any significant incremental ongoing costs on boards and fund investors compared to the ongoing costs under current practices.^[248] We acknowledge, however, that to the extent boards' current oversight of investment advisers' fair value calculations and boards' current practices with respect to review of valuation reports is inconsistent with the proposed rule's requirements, funds would bear ongoing costs to comply with the proposed rule.

Relatedly, to the extent that fair value determinations would be assigned to an investment adviser to the fund, such investment advisers would incur ongoing costs to satisfy their new fair value obligations. Those costs would be attributable to adopting and implementing policies and procedures, reporting, and recordkeeping to ensure compliance with the proposed rule's requirements. The magnitude of those costs would depend on how investment advisers' current practices compare to the requirements of the proposed rule. Investment advisers could demand higher fees as a compensation for the increased valuation responsibilities. Depending on the level of competition in the fund investment adviser industry, those higher fees could be passed on to fund investors in the form of higher fund fees. We lack data to estimate any cost increases and the pass-through rate of those cost increases to fund investors but we request comment on this issue in Section III.E. below.

Finally, to the extent that the board would assign the fair value determinations relating to any or all of fund investments to the investment adviser, the proposed rule would provide the adviser—which has conflicting interests—a greater role in fair value determinations relative to current practices.^[249] Nevertheless, we believe that any impact from such conflicts would be limited because the proposed rule contains explicit requirements related to the identification, assessment, and management of any material conflicts of interest of the investment adviser, including the requirement to reasonably segregate the investment adviser's process of making fair value determinations from the portfolio management, and funds currently have in place policies to manage conflicts of interest of investment advisers that may not be valuation specific.

4. Effects on Efficiency, Competition, and Capital Formation

Under the proposed rule, boards may assign fair value determinations to an investment adviser and oversee the investment adviser's fair value determinations instead of determining fair value themselves, which could free board resources tied to valuation and redirect them to oversight or other matters. As a result, the proposed rule could lead to more efficient use of boards' resources and therefore improve funds' governance for the benefit of fund investors. The proposed rule also could improve the efficiency of fund operations because it would allow boards more flexibility to oversee the investment advisers' fair value determinations instead of determining fair values themselves.

As discussed above, the proposed rule would mandate specific fair value policies and procedures and effective oversight of an assigned investment adviser, which could ultimately improve the efficiency of funds' asset prices. The proposed rule could improve the efficiency of asset prices because it could create a more robust valuation framework and it could help mitigate any conflicts of interest of the investment adviser, which ultimately could result in more accurate and unbiased asset prices. A potential increase in asset price efficiency could improve boards' monitoring of funds' and investment advisers' performance and could benefit capital formation because more accurate and unbiased prices permit the allocation of resources to their most efficient use. Nevertheless, we believe that any such effects likely would be small because many funds currently have in place fair value practices that are generally similar to the proposed rule's requirements and boards oversee the investment adviser's assistance with fair value calculations.

We do not believe that the proposed rule would have any material effects on competition because the effects of the rule likely would be small in light of the proposed rule's similarities to current practices. In particular, as discussed in Section III.C.3. above, the main costs arising from the proposed rule are the one-time costs to comply with the rule. Even though these costs could be more burdensome for smaller fund complexes, we believe that these costs would not affect competition in the fund industry, especially when considering that these are one-time costs that can be amortized over a number of years and because we believe that only few funds would incur costs at the higher end of the cost range estimate (i.e., between $100,000 and $600,000). Consequently, we believe that the proposed rule would not affect competition in the fund industry.

In addition, the proposed rule's requirement to reasonably segregate the investment adviser's process of making fair value determinations from the portfolio management likely would more significantly affect those smaller investment advisers that lack the staff and resources necessary to effect such segregation as efficiently as larger advisers and would otherwise need to hire additional personnel. Nevertheless, we do not believe that this requirement of the proposed rule would have a material effect on competition in the fund investment adviser industry because many smaller investment advisers to funds currently have in place processes to address the potential conflicts of interest whenever portfolio management personnel provides input to valuation.

D. Reasonable Alternatives

1. More Principles-Based Approach

The proposed rule mandates the performance of certain prescribed functions to determine the fair value of fund investments in good faith. As an alternative to the proposed rule, we considered a more principles-based approach that would not specify the types of fair value functions that must be performed, but instead would only state that funds should have in place policies and procedures, reporting, and recordkeeping that would allow fair values to be determined in good faith by the board of directors or the investment adviser. The benefits of such an approach would be that funds would have more flexibility to tailor their policies and procedures, reporting, and recordkeeping to their valuation needs. Nevertheless, under such an approach funds could be less certain on how to comply with the proposed rule. To the extent this alternative would reduce certainty for funds, it could increase compliance costs to the detriment of fund investors, and it would not adequately ensure that the board provides sufficient oversight over the investment adviser's fair value determinations.^[250] In addition, if certain funds within a fund complex would use the additional flexibility afforded by a more principles-based approach to set up policies and procedures, reporting, and recordkeeping arrangements that are different from one another, such flexibility could increase the cost of board oversight. This could occur because a board that is shared across funds within a fund complex would not be able to apply a similar framework across the various funds it oversees. Further, a more principles-based approach would not mandate a minimum prescribed set of fair value policies and procedures, reporting, and recordkeeping, unlike the proposed rule that would provide a consistent framework for funds to apply. Consequently, not all funds necessarily would put in place adequate policies and procedures, reporting, and recordkeeping to achieve accurate and unbiased fair value determinations.

2. Assignment of Responsibilities to Service Providers Other Than Investment Advisers

Under the proposed rule, the board may assign the fair value determinations to an investment adviser to the fund, which would carry out all of the functions required under the rule. As an alternative, we considered allowing the board to assign the fair value determinations to service providers other than the investment adviser, such as a pricing service provider. Such an approach would provide additional flexibility to the board to assign the fair value determinations to appropriate persons. As a result, this alternative could free up board resources tied to the determination of fair value and redirect them to oversight, in situations where an adviser was unwilling or unable to accept the responsibility to determine the fair value of fund investments and another third party was available to accept the assignment. Nevertheless, such an approach potentially could limit a board's ability to effectively oversee the service provider that performs the fair value determinations because the board does not have the same level of visibility, access to information, and control over the actions of service providers other than the investment adviser. Further, even though service providers may have a contractual obligation to perform valuation services for the fund, those service providers, unlike an adviser to a fund, may not owe a fiduciary duty to the fund, and thus their obligation to serve the fund's and its shareholders' best interests is limited. Hence, such an alternative approach could compromise the integrity of the fair values.

3. Not Permit Boards To Assign Fair Value Determinations to an Investment Adviser

As discussed in more detail above, unlike the current regulatory framework, the proposed rule would permit fund boards to assign the fair value determinations to an investment adviser. In addition, relative to the current regulatory framework, the proposed rule would mandate more specific fair value policies and procedures, reporting, and recordkeeping. As an alternative to the proposed rule, we considered not permitting fund boards to assign the fair value determinations to an investment adviser to the fund but instead only requiring funds to adopt the policies and procedures, reporting, and recordkeeping as described in the proposed rule. We also considered requiring boards periodically to ratify the fair value determinations calculated by the fund's adviser using the methodology determined by the board. Such an approach could prescribe minimum requirements with respect to valuation policies and procedures, reporting, and recordkeeping. Nevertheless, such an approach would not allow funds the flexibility to leverage the fair value expertise of the investment adviser and assign a role to the fund's board that is more in line with the board's experience and expertise. Relatedly, we believe that such an approach would not result in more efficient use of boards' time and more efficient fund operations, and would not result in improvements in fund governance, which would ultimately benefit fund investors.

E. Request for Comment

We request comment on all aspects of our economic analysis, including the potential costs and benefits of the proposed rule and alternatives thereto, and whether the proposed rule, if adopted, would promote efficiency, competition, and capital formation. Commenters are requested to provide empirical data, estimation methodologies, and other factual support for their views, in particular, on costs and benefits estimates. In addition, we request comment on the following:

58. Is our understanding regarding boards' current fair value practices correct? If not, please describe boards' current fair value practices. In particular, how do boards determine the fair values of fund investments in good faith? What type of assistance do boards receive with respect to fair value determinations? Who assists the board with the fair value determinations? To what extent and under what circumstances does information from pricing services assist the board with fair value determinations? What kinds of services do pricing services provide? What percentage of fund boards receive assistance with the fair value determinations? Does this percentage differ with the type of fund or with the type of fund investments? What types of fair value practices and policies and procedures do funds have in place? What types of reports related to valuation do fund boards currently receive and how frequently do they receive these reports? What types of records related to valuation do funds retain? For how long do they retain these records? Do these practices differ with the type of fund or with the type of fund investments?

59. Is our assumption correct that the vast majority of current and prospective fund boards would assign fair value determinations to an investment adviser under the proposed rule? If not, what percentage of current and prospective funds would assign the fair value determinations to an investment adviser to the fund? Do these percentages vary with the type of fund or with the type of fund investments? What factors would boards consider when deciding whether to assign the fair value determinations to an investment adviser to the fund?

60. What percentage of fund independent board members have valuation experience and expertise? Please provide data on the percentage of fund independent board members that have valuation experience and expertise by fund type.

61. Are there any entities affected by the proposed rule that are not discussed in the economic analysis? In which ways would those entities be affected by the proposed rule? Please provide an estimate of the number and size of those affected entities and of the nature and magnitude of the effect. Is our assessment correct that the effects of the proposed rule on UITs would be similar to the effects of the proposed rule on other funds, except for the fact that UITs would not bear any costs associated with oversight and reporting and their trustees would not receive any of the benefits associated with assigning fair value determinations to an investment adviser? Is our understanding correct that the proposed rule would not have significant effects on pricing services? If not, please describe any effects the proposed rule would have on pricing services.

62. Do UITs' exposures to investments that use Level 1, 2, and 3 inputs differ from the exposure of other registered investment companies? What percentage of UITs hold investments that use Level 1, 2, and 3 inputs respectively?

63. In which ways do funds' current practices differ from the policies and procedures, reporting, and recordkeeping and other activities mandated by the proposed rule? Is our understanding correct that current funds' practices are largely similar to the policies and procedures, reporting, and recordkeeping and other requirements of the proposed rule?

64. Are there any costs and benefits of the proposed rule that are not discussed in the economic analysis? If so, please describe the types of costs and benefits and provide a dollar estimate of these costs and benefits.

65. Please provide any estimates of the board time and other savings arising from the assignment of fair value determinations to an investment adviser to the fund under the proposed rule. What is the source of these savings? How would the board utilize any savings as the result of the assignment of the fair value determinations to an investment adviser to the fund under the proposed rule? Would the boards engage in additional activities at meetings or would the boards instead spend less time on fund matters? Please provide dollar estimates (mean, median, standard deviation, minimum, and maximum) of these savings? Would these savings differ by fund? If yes, in which way?

66. Please provide a list of activities that would give rise to one-time costs for funds under the proposed rule. Also please provide dollar estimates (mean, median, standard deviation, minimum, and maximum) of the one-time costs that funds would incur. Would these costs differ by fund? If yes, in which ways? What percentage of these costs would be borne by the board and what percentage by an investment adviser to the fund? What percentage of these costs would be passed on to fund investors in the form of higher operating expenses or higher management fees?

67. Is our understanding correct that the incremental ongoing operating costs for funds would be minimal under the proposed rule? If not, please provide an estimate of the number of funds that would bear ongoing costs under the proposed rule. Also, please describe the activities that would give rise to ongoing costs for funds under the proposed rule, and an estimate of the costs associated with each activity. Would these costs differ by fund? If yes, in which ways? Which of these costs would be borne by the board and which by the investment adviser to the fund? What percentage of these costs would be passed down to fund investors in the form of higher operating expenses or higher management fees?

68. Would the proposed rule increase the fees of investment advisers or trustees of UITs? If yes, why and how? Please provide an estimate of the increase in the investment advisers' or trustees' fees.

69. What would be the effects of the proposed rule, including any effects on efficiency, competition, and capital formation? Would the proposed rule be beneficial or detrimental to funds and their investors? Would the proposed rule affect competition in the fund industry? If yes, why? Would the proposed rule affect the efficiency of the prices of fund investments? If so, in which way?

70. Would a more principles-based approach relative to the proposed rule be preferable? If yes, why? If we did adopt such an approach, what safeguards would be necessary to ensure that fair value determinations are not influenced by conflicts of interest?

71. Would it be preferable to allow the board to assign the fair value determinations to service providers other than the investment adviser, such as a pricing service provider? If yes, why?

72. Would it be preferable to not permit boards to assign fair value determinations to an investment adviser to the fund but only mandate fair value policies and procedures, reporting, and recordkeeping requirements that are similar to the proposed rule's requirements? If yes, why?

IV. Paperwork Reduction Act Analysis

A. Introduction

Proposed rule 2a-5 would result in new “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995 (“PRA”).^[251] The title for the new collection of information would be “Rule 2a-5 under the Investment Company Act of 1940, Fair Value.” The Commission is submitting these collections of information to the Office of Management and Budget (“OMB”) for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently-valid control number.

The proposed rule would provide requirements for determining fair value in good faith for purposes of section 2(a)(41) and rule 2a-4 thereunder. This determination would involve assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records. The proposed rule would permit a fund's board of directors to assign the fair value determination relating to any or all fund investments to an investment adviser of the fund, which would carry out all of these requirements, subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability effectively to oversee the adviser's fair value determinations. As relevant here, the rule would require, on a per fund basis, the adoption and implementation of certain policies and procedures designed to address the process for determining fair value in good faith, keeping of certain records regarding the fair value process, and, if the board assigns the adviser to determine fair value, adviser reporting to the board in both periodic and as needed reports with some extra recordkeeping.^[252]

The respondents to proposed rule 2a-5 would be registered investment companies and BDCs.^[253] We estimate that 9,986 funds would be affected by rule 2a-5, of which 9,501 are not UITs.^[254] Compliance with rule 2a-5 would be mandatory for any fund that would need to determine fair value under the Act. To the extent that records would be required to be created and maintained under the rule are provided to the Commission in connection with examinations or investigations, such information would be kept confidential subject to the provisions of applicable law.

B. Policies and Procedures

Proposed rule 2a-5 would require the adoption and implementation of fair value policies and procedures, which would address the process for the determination of the fair value of the fund's investments under the proposed rule.^[255] The fair value policies and procedures are designed to help ensure that the determination of fair value is carried out effectively and to facilitate board oversight. The policies and procedures, as proposed, must be reasonably designed to achieve compliance with the certain requirements of the proposed rule, which are: (1) Periodically assessing any material risks associated with the determination of the fair value, including material conflicts of interest, and managing those identified valuation risks; (2) selecting and applying in a consistent manner methodologies for determining and calculating the fair value; (3) testing the appropriateness and accuracy of the fair value methodologies that have been selected; and (4) selecting and overseeing pricing service providers, if used.

We believe that the fund's board or adviser likely would establish the fair value policies and procedures by adjusting the current systems for implementing and enforcing the compliance policies and procedures of the fund (if the requirements are not assigned) or the adviser's (if the requirements are assigned). While funds and advisers have policies and procedures in place to address compliance with the federal securities laws (among other obligations), including fair value determinations, they would need to update their existing policies and procedures to account for the specific requirements of proposed rule 2a-5. To comply with this obligation, we believe that fund boards or advisers (by assignment by the board) would use in-house legal and compliance counsel to update existing policies and procedures to account for the requirements of proposed rule 2a-5. For purposes of these PRA estimates, we assume that either the fund or the adviser would review the fair value policies and procedures annually (for example, to assess whether the fair value methodology requires adjustments). We therefore have estimated initial and ongoing burdens associated with the proposed policies and procedures requirement. As discussed above, we estimate that approximately 9,986 funds may rely on the proposed rule and therefore would require these funds or their advisers to adopt and implement fair value policies and procedures.

Table 1 below summarizes the proposed PRA initial and ongoing burden estimates associated with the policies and procedures requirements under proposed rule 2a-5.

C. Board Reporting

The proposed rule would require, if the board assigns the fair value determinations to an adviser of the fund, that the adviser report to the fund's board in writing (1) a quarterly report containing an assessment of the adequacy and effectiveness of the adviser's process for determining the fair value of the assigned portfolio of investments and (2) promptly (but in no event later than three business days after the adviser becomes aware of the matter) on matters associated with the adviser's process that materially affect or could have materially affected the fair value of the assigned portfolio of investments. These reports would be required to include such information as may be reasonably necessary for the board to evaluate the matters covered in the report.^[256] The periodic reports that would be required by the proposed rule would have a minimum of five items required as part of the report,^[257] and the prompt reports must include material weaknesses in the design or implementation of the adviser's fair value determination process or material changes in the fund's risks as would be required elsewhere under the proposal.^[258] UITs could not assign fair value determinations to an adviser under the proposed rule because they are unmanaged and therefore would not be subject to this collection of information.^[259] We estimate that 9,501 funds would utilize the proposed rule and therefore be subject to these requirements.^[260]

Table 2 below summarizes the proposed PRA initial and ongoing burden estimates associated with the board reporting requirements under proposed rule 2a-5.

D. Recordkeeping

Proposed rule 2a-5 would require the maintenance of certain records, specifically (1) appropriate documentation to support fair value determinations, including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations and (2) copies of the policies and procedures as required elsewhere under the proposed rule.^[261] Further, if the board assigns fair value determinations to an adviser, the fund must maintain copies of (3) the reports and other information provided to the board as required elsewhere under the proposed rule and (4) a specified list of the investments or investment types whose fair value determination has been assigned to the adviser.^[262] We estimate that 9,986 funds would be subject to the proposed rule and therefore to these requirements.^[263]

Table 3 below summarizes the proposed PRA initial and ongoing burden estimates associated with the recordkeeping requirements under proposed rule 2a-5.

E. Proposed Rule 2a-5 Total Estimated Burden

As summarized in Table 4 below, we estimate that the total hour burdens and time costs associated with proposed rule 2a-5, including the burden associated with the adoption and implementation of fair value policies and procedures, board reporting, and recordkeeping requirements, amortized over three years, would result in an average aggregate annual burden of 274,758 hours and an average aggregate annual monetized time cost of $253,654,559. We also estimate that, amortized over three years, there would be external costs of $44,965,600 associated with this collection of information. Therefore, each fund required to comply with the rule would incur an average annual burden of approximately 27.51 hours, at an average annual monetized time cost of approximately $25,401, and an external cost of $4,503 to comply with proposed rule 2a-5.

F. Request for Comment

We request comment on whether these estimates are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (1) Evaluate whether the proposed collections of information are necessary for the proper performance of the functions of the Commission, including whether the information will have practical utility; (2) evaluate the accuracy of the Commission's estimate of the burden of the proposed collections of information; (3) determine whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and (4) determine whether there are ways to minimize the burden of the collections of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology.

Persons wishing to submit comments on the collection of information requirements of the proposed rules and amendments should direct them to the OMB: MBX.OMB.OIRA.SEC_desk_officer@omb.eop.gov, and should send a copy of their comments to, Vanessa Countryman, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090, with reference to File No. S7-07-20. OMB is required to make a decision concerning the collections of information between 30 and 60 days after publication of this release; therefore a comment to OMB is best assured of having its full effect if OMB receives it within 30 days after publication of this release. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in writing, refer to File No. S7-07-20, and be submitted to the Securities and Exchange Commission, Office of FOIA Services, 100 F Street NE, Washington, DC 20549-2736.

V. Initial Regulatory Flexibility Analysis

The Commission has prepared the following Initial Regulatory Flexibility Analysis (“IRFA”) in accordance with section 3(a) of the Regulatory Flexibility Act (“RFA”).^[264] It relates to proposed rule 2a-5.

A. Reasons for and Objectives of the Proposed Actions

The Commission is proposing new rule 2a-5 in order to address practices and the role of the board of directors with respect to the fair value of the investments of fund. Under section 2(a)(41), the board must determine in good faith the fair value of fund assets for which no market quotations are readily available. The proposed rule is designed to specify how a board or adviser must make good faith determinations of fair value as well as when the board can assign this function to an adviser to the fund, while still ensuring that fund investments are valued in a way consistent with the Investment Company Act.

The proposed rule would provide requirements for determining fair value in good faith for purposes of section 2(a)(41) of the Act and rule 2a-4 thereunder. This determination would involve assessing and managing material risks associated with fair value determinations; selecting, applying, and testing fair value methodologies; evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records. The proposed rule would permit a fund's board of directors to assign these requirements to an investment adviser to the fund for some or all of the fund's investments, subject to board oversight and certain reporting, recordkeeping, and other requirements designed to facilitate the board's ability effectively to oversee the adviser's fair value determinations. The proposed rule would also define when market quotations are readily available under section 2(a)(41) of the Act. Lastly, the proposed rule would have the trustee of a UIT carry out the requirements of the proposed rule. The requirements associated with the fair value as determined in good faith and readily available market quotations are designed to protect investors from improper valuations and reflect our view of current market best practices.^[265] The requirements associated with the assignment of responsibilities to an adviser are designed to ensure that the board effectively oversees an assigned adviser, including receiving sufficient information to do so.^[266] The policies and procedures and recordkeeping requirements are designed to help ensure compliance with the other requirements.^[267]

All of these requirements are discussed in detail in section II of this release. The costs and burdens of these requirements on small funds and investment advisers are discussed below as well as above in our Economic Analysis and Paperwork Reduction Act Analysis, which discuss the applicable costs and burdens on all funds and investment advisers.^[268]

B. Legal Basis

The Commission is proposing new rule 2a-5 under the authority set forth in sections 2(a), 6(c), 31(a), 31(c), and 38(a) of the Investment Company Act of 1940 [15 U.S.C. 80a-2(a), 80a-6(c), 80a-30(a), 80a-30(c), and 80a-37(a)].

C. Small Entities Subject to Proposed Rules

For purposes of Commission rulemaking in connection with the Regulatory Flexibility Act, an investment company is a small entity if, together with other investment companies in the same group of related investment companies, it has net assets of $50 million or less as of the end of its most recent fiscal year (a “small fund”).^[269] Commission staff estimates that, as of December 2019, approximately 38 registered open-end mutual funds, 8 registered ETFs, 30 registered closed-end funds, 2 UITs, and 14 BDCs (collectively, 92 funds) are small entities.^[270]

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

Proposed rule 2a-5 would require fair value determinations under the Act be made according to a specific process for affected funds, including those that are small entities. This process would include the adoption of policies and procedures reasonably designed to achieve compliance with the requirements of the proposed rule and certain recordkeeping requirements. Further, the proposed rule would permit certain fund boards to assign fair value determinations to an adviser to the fund if the adviser, in addition to the above, adopts certain policies and procedures, makes certain reports to the fund's board regarding the fair value process in writing. Funds would also be required to keep certain additional records in such circumstances. We therefore believe that there are three principal reporting, recordkeeping, or other compliance requirements associated with the proposed rule: (1) The establishment and implementation of policies and procedures, including establishing and applying fair value methodologies, (2) recordkeeping requirements, and (3) board reporting requirements.

1. Policies and Procedures

The policies and procedures that would be required under the proposed rule would need to be reasonably designed to achieve compliance with the requirements of the rule. Specifically, these requirements include (1) the assessment and management of risks associated with the determination of fair value, (2) establishing and applying fair value methodologies, (3) testing fair value methodologies, and (4) evaluating pricing services.^[271] Further, if the board assigns fair value determinations under the proposed rule to an investment adviser to the fund, the adviser's policies and procedures must meet certain requirements. In addition to the other requirements above, these policies and procedures must specify the titles of the persons responsible for determining the fair value of assigned investments, including by specifying the particular functions for which they are responsible, and reasonably segregating the process of making fair value determinations from the portfolio management of the fund.^[272]

These requirements are designed to implement the proposed rule's requirements effectively which, in turn, are designed to protect investors from improper valuations. They are also designed to facilitate the board's oversight of these functions when they are assigned to an adviser to the fund. These requirements will impose burdens on all funds, including those that are small entities. The specifics of these burdens are discussed in the Economic Analysis and Paperwork Reduction Act sections above.^[273]

There are different factors that would affect whether a smaller fund incurs costs related to this requirement that are on the higher or lower end of the estimated range. For example, we would expect that smaller funds—and more specifically, smaller funds that are not part of a fund complex—may not have existing policies and procedures that include all of the elements that would be required of policies and procedures under the proposed rule. Also, while we would expect larger funds or funds that are part of a large fund complex to incur higher costs related to this requirement in absolute terms relative to a smaller fund or a fund that is part of a smaller fund complex, we would expect a smaller fund to find it more costly, per dollar managed, to comply with the proposed requirement because it would not be able to benefit from a larger fund complex's economies of scale.^[274]

2. Recordkeeping

The recordkeeping requirements of the proposed rule are designed to help ensure compliance with the rule's requirements and aid in oversight. The proposed rule would require the fund to keep the following records: (1) Appropriate documentation to support fair value determinations, including information regarding the specific methodologies applied and the assumptions and inputs considered when making fair value determinations for at least five years from the time the determination was made, the first two years in an easily accessible place and (2) A copy of the fair value policies and procedures that are in effect, or were in effect at any time within the past five years, in an easily accessible place.^[275] Further, should the board assign the fair value determination, the fund must keep, in addition to the records above, copies of the reports and other information provided to the board for at least five years after the end of the fiscal year in which the documents were made, the first two years in an easily accessible place and a specified list of the investments or investment types whose fair value determination has been assigned to the adviser, in each case for at least five years after the end of the fiscal year in which the determinations were provided to the board or the investments or investment types were assigned to the adviser, the first two years in an accessible place.^[276]

These requirements will impose burdens on all funds, including those that are small entities. The specifics of these burdens are discussed in the Economic Analysis and Paperwork Reduction Act sections above.^[277] There are different factors that would affect whether a smaller fund incurs costs relating to this requirement that are on the higher or lower end of the estimated range. For example, we would expect that smaller funds—and more specifically, smaller funds that are not part of a fund complex—may not have recordkeeping systems that would meet all the elements that would be required under the proposed rule. Also, while we would expect larger funds or funds that are part of a large fund complex to incur higher costs related to this requirement in absolute terms relative to a smaller fund or a fund that is part of a smaller fund complex, we would expect a smaller fund to find it more costly, per dollar managed, to comply with the proposed requirement because it would not be able to benefit from a larger fund complex's economies of scale.^[278]

3. Board Reporting

The requirement for board reporting by the fund's adviser is designed to ensure that the board can exercise sufficient oversight over the fair value process. The proposal would require two general types of reports, a periodic one and a prompt one. Periodic reports would consist of the adviser's quarterly assessment in writing of the adequacy and effectiveness of the adviser's fair value process for determining the fair value of the assigned portfolio of investments, including some specific summaries and descriptions. The prompt reporting requirement would require advisers to promptly inform the board, but in no event later than three business days after the adviser becomes aware of the matter, of matters that materially affect or could materially affect the fair value of the assigned portfolio of investments, including a significant deficiency or material weakness in the design or implementation of the adviser's fair value determination process or material changes in valuation risks.^[279]

These requirements will impose burdens on all funds, including those that are small entities. The specifics of these burdens are discussed in the Economic Analysis and Paperwork Reduction Act sections above.^[280] There are different factors that would affect whether a smaller fund incurs costs related to this requirement that are on the higher or lower end of the estimated range. For example, we would expect that smaller funds—and more specifically, smaller funds that are not part of a fund complex—may not have an advisory agreement that has a reporting mechanism that would meet all the elements that would be required under the proposed rule. Also, while we would expect larger funds or funds that are part of a large fund complex to incur higher costs, via increased advisory fees for advisers to take on this responsibility on behalf of such funds, related to this requirement in absolute terms relative to a smaller fund or a fund that is part of a smaller fund complex, we would expect a smaller fund to find it more costly, per dollar managed, to comply with the proposed requirement because it would not be able to benefit from a larger fund complex's economies of scale.^[281]

E. Duplicative, Overlapping, or Conflicting Federal Rules

Other than as discussed below, Commission staff has not identified any federal rules that duplicate, overlap, or conflict with proposed rule 2a-5. As discussed in more detail above,^[282] rule 38a-1 also would apply to a fund's obligations under the proposed rule. Rule 38a-1 requires a fund's board, including a majority of its independent directors, to approve the fund's policies and procedures, including those on fair value, and those of each investment adviser and other specified service providers, based upon a finding by the board that the policies and procedures are reasonably designed to prevent violation of the federal securities laws.^[283] Rule 38a-1 also requires that the fund's CCO provide an annual report to the fund's board that must address any material changes to compliance policies and procedures.^[284]

Ultimately, we do not believe that the proposed rule adds cumulative regulatory burdens on small funds without any gain in regulatory benefits. The proposed rule would differ from the requirements of rule 38a-1 in that proposed rule 2a-5 would mandate that funds, including small funds, adhere to more specific fair value practices as well as policies and procedures, reporting, and recordkeeping requirements not currently required in the text of rule 38a-1. As we state above, however, to the extent that adviser policies and procedures under proposed rule 2a-5 would otherwise be duplicative of fund valuation policies under rule 38a-1, a fund could adopt the rule 2a-5 policies and procedures of the adviser in fulfilling its rule 38a-1 obligations to avoid any duplication.^[285]

F. Significant Alternatives

The Regulatory Flexibility Act directs the Commission to consider significant alternatives that would accomplish our stated objective, while minimizing any significant economic impact on small entities. We considered the following alternatives for small entities in relation to our proposal: (1) Exempting funds that are small entities from the proposed reporting, recordkeeping, and other compliance requirements, to account for resources available to small entities; (2) establishing different reporting, recordkeeping, and other compliance requirements or frequency, to account for resources available to small entities; (3) clarifying, consolidating, or simplifying the compliance requirements under the proposal for small entities; and (4) using performance rather than design standards.

We do not believe that exempting small funds from the provisions in proposed rule 2a-5 would permit us to achieve our stated objectives, principally to protect investors from improper valuations. Further, the board reporting and additional recordkeeping provisions of proposed rule 2a-5 only affect fund boards that assign fair value determinations to a fund adviser and, therefore, the rule would require funds to comply with these specific requirements only if they assigned responsibilities to their adviser. However, we expect that most funds holding securities that must be fair valued will do so. Therefore if a board to a small entity does not do this and instead performs its statutory function directly, then the small entity would not be subject to these provisions of proposed rule 2a-5.

We estimate that 72% of all funds would be subject to the proposed rule in making fair value determinations.^[286] This estimate indicates that some funds, including some small funds, would be unaffected by the proposed rule. However, for small funds that would be affected by our proposed rule, providing an exemption for them could subject investors in small funds to a higher degree of risk than investors to large funds that would be required to comply with the proposed elements of the rule.

As discussed throughout this release, we believe that the proposed rule would result in investor protection benefits, and these benefits should apply to investors in smaller funds as well as investors in larger funds. We therefore do not believe it would be appropriate to exempt small funds from the proposed rule's requirements, or to establish different requirements applicable to funds of different sizes under these provisions to account for resources available to small entities. We believe that all of the proposed elements of rule 2a-5 should work together to produce the anticipated investor protection benefits, and therefore do not believe it is appropriate to except smaller funds because we believe this would limit the benefits to investors in such funds.

We also do not believe that it would be appropriate to subject small funds to different reporting, recordkeeping, and other compliance requirements or frequency. Similar to the concerns discussed above, if the proposal included different requirements for small funds, it could raise investor protection concerns for investors in small funds in that small funds face the same conflicts of interest that can lead to mispricing and otherwise harm investors that larger funds do.

We do not believe that clarifying, consolidating, or simplifying the compliance requirements under the proposal for small funds, beyond that already proposed for all funds, would permit us to achieve our stated objectives. Again, this approach would raise investor protection concerns for investors in small funds. We believe, as outlined above in the discussion of the proposed rule and the guidance contained in this release, that the requirements of the proposed rule are, to some extent, current industry practice under existing rules, with some changes from current practice. As a result, we think that the proposed rule could result in a reduction in the current burdens experienced by small entities to the extent that they are subject to the proposed rule.

The costs associated with proposed rule 2a-5 would vary depending on the fund's particular circumstances, and thus the proposed rule could result in different burdens on funds' resources. In particular, we expect that a fund that does not have policies and procedures, reporting, or recordkeeping practices similar to those proposed in the rule would need to modify those practices. Thus, to the extent a fund that is a small entity already has a fair value process that is consistent with the requirements of the proposed rule, we believe it would incur relatively low costs to comply with it. However, we believe that it is appropriate to correlate the costs associated with the proposed rule with the fund's actual fair value process, and not necessarily with the fund's size in light of our investor protection objectives.

Finally, with respect to the use of performance rather than design standards, the proposed rule generally uses performance standards for all funds subject to the proposed rule, regardless of size. We believe that providing funds with the flexibility permitted in the proposal with respect to designing specific fair value process is appropriate because of the fact-specific nature of making fair value determinations.

G. Request for Comment

73. The Commission requests comment regarding this analysis. We request comment on the number of small entities that would be subject to our proposal and whether our proposal would have any effects that have not been discussed. We request that commenters describe the nature of any effects on small entities subject to our proposal and provide empirical data to support the nature and extent of such effects. We also request comment on the estimated compliance burdens of our proposal and how they would affect small entities.

VI. Consideration of Impact on the Economy

For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 (“SBREFA”), the Commission must advise OMB whether a proposed regulation constitutes a “major” rule. Under SBREFA, a rule is considered “major” where, if adopted, it results in or is likely to result in:

• An annual effect on the economy of $100 million or more;
• A major increase in costs or prices for consumers or individual industries; or
• Significant adverse effects on competition, investment, or innovation.

We request comment on whether our proposal would be a “major rule” for purposes of SBREFA. We solicit comment and empirical data on:

• The potential effect on the U.S. economy on an annual basis;
• Any potential increase in costs or prices for consumers or individual industries; and
• Any potential effect on competition, investment, or innovation.

Commenters are requested to provide empirical data and other factual support for their views to the extent possible.

VII. Statutory Authority

The Commission is proposing new rule 2a-5 under the authority set forth in sections 2(a), 6(c), 31(a), 31(c), and 38(a) of the Investment Company Act of 1940 [15 U.S.C. 80a-2(a), 80a-6(c), 80a-30(a), 80a-31(c), and 80a-37(a)].

List of Subjects

17 CFR Part 210

• Accountants
• Accounting
• Banks, banking
• Employee benefit plans
• Holding companies
• Insurance companies
• Investment companies
• Oil and gas exploration
• Reporting and recordkeeping requirements
• Securities
• Utilities

17 CFR Part 270

• Investment companies
• Reporting and recordkeeping requirements
• Securities

For the reasons set out in the preamble, title 17, chapter II of the Code of Federal Regulation is proposed to be amended as follows:

PART 210—FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934, INVESTMENT COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975

1. The authority citation for part 210 continues to read, in part, as follows:

Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 77aa(25), 77aa(26), 77nn(25), 77nn(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-20, 80a-29, 80a-30, 80a-31, 80a-37(a), 80b-3, 80b-11, 7202 and 7262, and sec. 102(c), Pub. L. 112-106, 126 Stat. 310 (2012), unless otherwise noted.

2. Section 210.6-03 is amended by revising paragraph (d) to read as follows:

PART 270—RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

3. The authority citation for part 270 continues to read, in part, as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted.

4. Section 270.2a-5 is added to read as follows:

Footnotes