[Federal Register Volume 85, Number 93 (Wednesday, May 13, 2020)]
[Proposed Rules]
[Pages 28734-28770]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-08854]



[[Page 28733]]

Vol. 85

Wednesday,

No. 93

May 13, 2020

Part III





Securities and Exchange Commission





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17 CFR Parts 210 and 270





 Good Faith Determinations of Fair Value; Proposed Rule

  Federal Register / Vol. 85 , No. 93 / Wednesday, May 13, 2020 / 
Proposed Rules  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210 and 270

[Release No. IC-33845; File No. S7-07-20]
RIN 3235-AM71


Good Faith Determinations of Fair Value

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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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

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    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\
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    \1\ Section 2(a)(41) of the Investment Company Act. See also 
Investment Company Act rule 2a-4.
    \2\ The Investment Company Act requires registered investment 
companies that issue redeemable securities to sell and redeem their 
shares at prices based on the current net asset value of those 
shares. See section 22(c) of the Investment Company Act and rule 
22c-1(a) thereunder. Rule 2a-4 defines the term ``current net asset 
value'' of a redeemable security issued by a registered investment 
company and provides, similar to section 2(a)(41)(B), that 
``[p]ortfolio securities with respect to which market quotations are 
readily available shall be valued at current market value, and other 
securities and assets shall be valued at fair value as determined in 
good faith by the board of directors of the registered company.'' 
Rule 22c-1(a) requires open-end funds to sell, redeem, or purchase 
shares at a price based on their current NAV next computed following 
receipt of an order.
     Although closed-end funds are not subject to rules 2a-4 and 
22c-1 under the Investment Company Act, section 23(b) limits the 
ability of closed-end funds to sell their common stock at a price 
below current NAV. Section 23(c) of the Investment Company Act 
provides for the repurchases of closed-end fund shares. The shares 
of closed-end funds (including business development companies 
(``BDCs'')) that are listed on an exchange often trade at a premium 
or discount to NAV. See Item 1.1(i) of Form N-2 (requiring closed-
end funds whose securities have no history of public trading to 
include ``a statement describing the tendency of closed-end fund 
shares to trade frequently at a discount from net asset value'').
    \3\ See Investment Company Liquidity Risk Management Programs, 
Investment Company Act Release No. 32315 (Oct. 13, 2016) 
(``Liquidity Risk Management Release'') (adopting rule 22e-4 under 
the Investment Company Act and noting ``the risk of shareholder 
dilution associated with improper fund pricing'').
     If fund shares are overpriced, selling shareholders will 
receive too much for their shares, and purchasing shareholders will 
pay too much for their shares. On the other hand, if fund shares are 
underpriced, selling shareholders will receive too little for their 
shares, and purchasing shareholders will pay too little for their 
shares. See generally Investment Trusts and Investment Companies: 
Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking 
and Currency, 76th Cong., 3d Sess. 136-38 (1940) (discussing the 
effect of dilution on fund shareholders).
    \4\ See section 205 of the Investment Advisers Act of 1940 
(``Advisers Act'') (permitting a fund's adviser to receive 
compensation based upon the total value of the fund and permitting 
certain specified types of performance fee arrangements with funds).
    \5\ See, e.g., Item 3 of Form N-1A (requiring annual fund 
operating expenses to be disclosed in the fund's prospectus as a 
percentage of the value of a shareholder's investment); Item 4(b)(2) 
of Form N-1A (requiring certain disclosures about fund performance 
in fund prospectuses); Item 4.1 and Instruction 4.b. to Item 24 of 
Form N-2 (requiring disclosure of the fund's NAV in its prospectus 
and annual report); Item 6 of Form N-CSR and Sec.  210.12-12 of 
Regulation S-X (requiring a schedule of the fund's investments, 
including the value of the investment, in the fund's annual report).
    \6\ See Rule 22e-4(b)(1)(iv) (generally prohibiting an open-end 
fund from acquiring an illiquid investment if such investment would 
cause more than 15% of such fund's net assets to be invested in 
illiquid investments). See also Liquidity Risk Management Release, 
supra footnote 3; Instruction 4 to Item 9(b)(1) of Form N-1A 
(requiring a fund to disclose any policy to invest more than 25% of 
its net assets in a particular industry or group of industries).
    \7\ Fund advisers may have an incentive to overvalue fund 
assets, for example, to increase fees, but also in some cases may 
have incentives to undervalue fund assets, for example to smooth 
reported returns or comply with investment policies and 
restrictions. See In re Piper Capital Management, et al., Investment 
Company Act Release No. 26167 (Aug. 26, 2003) (Commission opinion) 
(``Piper'') (``the record shows that Respondents determined to 
smooth or ratchet down gradually the Fund's NAV over a period of 
days. It appears that Respondents sought to prevent an abrupt drop 
in the Fund's NAV as a result of updating the stale prices.''). See 
also Gjergi Cici, et al., Missing the Marks? Dispersion in Corporate 
Bond Valuations Across Mutual Funds, 101 J. Fin. Econ. 206 (2011) 
(observing evidence of price smoothing behavior in mutual funds and 
expressing concern that such smoothing may result in sub-optimal 
investment decisions) (``Cici et al. 2011'').
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    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\
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    \8\ See infra footnote 11.
    \9\ See, e.g., 15 U.S.C. 77l(a)(2); 15 U.S.C. 77k; 15 U.S.C. 
78j(b); 15 U.S.C. 80a-33(b); 17 CFR 240.10b-5; 17 CFR 270.22c-1(a); 
17 CFR 210.4-01(a)(1); 17 CFR 275.206(4)-8.
     Section 206(1) of the Advisers Act makes it unlawful for an 
investment adviser to employ any device, scheme or artifice to 
defraud any client or prospective client. Section 206(2) of the 
Advisers Act makes it unlawful for an investment adviser to engage 
in any transaction, practice or course of business that operates as 
a fraud or deceit upon any client or prospective client. The 
Commission has brought enforcement actions under sections 206(1) 
and/or 206(2) of the Advisers Act against advisers for material 
misstatements or omissions to a fund's board (such as the failure to 
disclose that the adviser is not complying with the fund's stated 
valuation procedures) or willfully or recklessly aiding and abetting 
the misvaluing of fund investments. See, e.g., In re Morgan Asset 
Management, et al., Investment Company Act Release No. 29704 (June 
22, 2011) (settlement) (``In re Morgan Asset Management'').
    \10\ Rule 6-02(b) of Regulation S-X defines the term ``value'' 
to have the same meaning as in section 2(a)(41)(B) of the Investment 
Company Act.
    \11\ Section 2(a)(41) of the Investment Company Act defines 
``value'' with respect to the assets of registered investment 
companies. Section 59 of the Investment Company Act makes section 
2(a)(41) applicable to BDCs. Section 2(a)(41)(A) provides the 
definition of ``value'' under the Investment Company Act for 
purposes of whether an issuer is an investment company under section 
3, is a ``diversified company'' or a ``non-diversified company'' 
under section 5, or exceeds certain investment limitations under 
section 12. Section 28(b) of the Investment Company Act contains 
provisions for the valuation of the investments of face-amount 
certificate companies. Section 2(a)(41)(B) defines value for all 
other purposes under the Investment Company Act. Section 
2(a)(41)(A)(iii) provides that investments acquired after the last 
preceding quarter shall be valued at the cost thereof. In certain 
circumstances, section 2(a)(41) permits directors to determine in 
good faith the value of securities issued by controlled companies 
even though market quotations are available for such securities.
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    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

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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.
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    \12\ Statement Regarding ``Restricted Securities,'' Accounting 
Series Release No. 113 (Oct. 21, 1969); Accounting for Investment 
Securities by Registered Investment Companies, Accounting Series 
Release No. 118 (Dec. 23, 1970). In 1982, the Commission codified 
ASR 113 and ASR 118 in the ``Codification of Financial Reporting 
Policies'' as section 404.04: `` `Restricted' Securities'' and 
section 404.03: ``Accounting, Valuation and Disclosure of Investment 
Securities,'' respectively. See Codification of Financial Reporting 
Policies, Investment Company Act Release No. 12376 (Apr. 15, 1982) 
(codifying certain existing Accounting Series Releases, including 
ASR 113 and ASR 118). ASR 113 and ASR 118 continue to be included in 
the list of interpretive releases relating to the Investment Company 
Act found in 17 CFR part 271 as Investment Company Act Release Nos. 
5847 and 6295, respectively. We refer to the releases herein as ASR 
113 and ASR 118.
    \13\ We generally use the term ``fair value'' in this release as 
that term is used in the definition of ``value'' in the Investment 
Company Act, that is, the value of securities for which no readily 
available market quotations exist. See section 2(a)(41) of the 
Investment Company Act and supra footnote 11.
     In contrast to the Investment Company Act, FASB Accounting 
Standard Codification Topic 820: Fair Value Measurement (``ASC Topic 
820'') uses the term ``fair value'' to refer generally to the value 
of an asset or liability, regardless of whether that value is based 
on readily available market quotations or on other inputs. 
Accordingly, when we use the term fair value in the release we are 
using it to mean fair value as defined under the Investment Company 
Act, unless we specifically note that we mean fair value under ASC 
Topic 820, such as in the sections below that discuss proposed 
rescission of the accounting guidance. See also infra notes 30 and 
141.
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    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\
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    \14\ ASR 118 at 19988 (``it is incumbent upon the Board of 
Directors . . . to determine the method of arriving at the fair 
value of each such security''). See also Money Market Fund Reform; 
Amendments to Form PF, Investment Company Act Release No. 31166 
(July 23, 2014) (``2014 Money Market Fund Release'') at n.896 
(citing ASR 118). In ASR 113, the Commission similarly stated:
     ``It is the responsibility of the board of directors to 
determine the fair value of each issue of restricted securities in 
good faith . . . . While the board may, consistent with this 
responsibility, determine the method of valuing each issue of 
restricted securities in the company's portfolio, it must 
continuously review the appropriateness of any method so 
determined.''
    \15\ ASR 118 at 19988 (``it is incumbent upon the Board of 
Directors to satisfy themselves that all appropriate factors 
relevant to the fair value of securities for which market quotations 
are not readily available have been considered''). See also 2014 
Money Market Fund Release, supra footnote 14, at n.896 (citing ASR 
118).
    \16\ ASR 118.
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    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\
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    \17\ See Use of Derivatives by Registered Investment Companies 
and Business Development Companies; Required Due Diligence by 
Broker-Dealers and Registered Investment Advisers Regarding Retail 
Customers' Transactions in Certain Leveraged/Inverse Investment 
Vehicles, Investment Company Act Release No. 33704 (``Derivatives 
Release'') (Nov. 25, 2019) (noting the dramatic growth in the volume 
and complexity of the derivatives markets over the past two decades, 
and the increased use of derivatives by certain funds); Use of 
Derivatives by Investment Companies under the Investment Company Act 
of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) at 
69 (noting that ``[v]aluation of some derivatives may present 
special challenges for funds'').
     The fund industry has grown tremendously in the intervening 
years. For example, in December 1969, open-end funds had net assets 
of over $53 billion. See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 2 
(1970). As of August 31, 2019, there were 12,040 open-end funds 
registered with the Commission with total net assets of nearly $28 
trillion. (We estimate the number of registered investment companies 
and their net assets by reviewing all Forms N-CEN filed with the 
Commission between June 2018 and August 2019.) Moreover, as of June 
2019, there were 99 BDCs with $63 billion in total net assets. 
(Estimates of the number of BDCs and their net assets are based on a 
staff analysis of Form 10-K and Form 10-Q filings as of June 30, 
2019.) BDCs, which did not exist in 1970, must invest at least 70% 
of their assets in certain investments that may be difficult to 
value. See Section 55(a) of the Act.
    \18\ For example, FINRA's TRACE introduced in 2002 is an over-
the-counter real-time price dissemination service for the fixed 
income market. See https://www.finra.org/sites/default/files/TRACE_Overview.pdf
    \19\ For example, the Electronic Municipal Market Access 
(``EMMA'') website, available since 2009, ``provides free public 
access to objective municipal market information and interactive 
tools for investors, municipal entities and others.'' See https://emma.msrb.org/#.
    \20\ 2014 Money Market Fund Release, supra footnote 14 (``many 
funds . . . use evaluated prices provided by third-party pricing 
services to assist them in determining the fair values of their 
portfolio securities'').
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    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\

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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\
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    \21\ Sarbanes-Oxley Act, Public Law 107-204, 116 Stat. 745.
    \22\ See Sarbanes-Oxley Act, supra footnote 21, at Title I Sec. 
101(a).
     PCAOB auditing standards apply to the preparation or issuance 
of ``audit reports,'' which are defined to include documents, 
reports, notices, or other records that, among other things, are 
prepared following an audit performed for purposes of compliance by 
an issuer, broker, or dealer with the requirements of the securities 
laws. See PCAOB rule 3200; PCAOB rule 1001(a)(vi). See also PCAOB 
rule 1001(i)(iii) (defining the term ``issuer'' to include issuers 
(as defined in Section 3 of the Securities Exchange Act of 1934 (the 
``Exchange Act'')), the securities of which are registered under 
Section 12 of the Exchange Act, or that are required to file reports 
under the Exchange Act or that file or have filed registration 
statements that have not yet become effective under the Securities 
Act of 1933 (the ``Securities Act''), and that have not been 
withdrawn).
    \23\ See Sarbanes-Oxley Act, supra footnote 21, at Title I Sec. 
101(c)(2).
    \24\ The federal securities laws for this purpose are the 
Securities Act, the Exchange Act, the Sarbanes-Oxley Act, the Trust 
Indenture Act of 1939, the Investment Company Act, the Advisers Act, 
and the Securities Investor Protection Act of 1970, and the rules, 
regulations and Commission orders thereunder. See PCAOB rule 
1001(s)(ii); section 3(a)(47) of the Exchange Act.
    \25\ The Commission adopted rule 30a-3 and a number of other 
rules in order to implement certain certification requirements of 
the Sarbanes-Oxley Act, supra footnote 21, that are applicable to 
companies filing reports under section 13(a) or 15(d) of the 
Exchange Act, and to extend those requirements to all registered 
management investment companies other than small business investment 
companies registered on Form N-5. See Certification of Management 
Investment Company Shareholder Reports and Designation of Certified 
Shareholder Reports as Exchange Act Periodic Reporting Forms; 
Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley 
Act, Investment Company Act Release No. 25914 (Jan. 27, 2003) 
(adopting Investment Company Act rule 30a-3); Management's Report on 
Internal Control Over Financial Reporting and Certification of 
Disclosure in Exchange Act Periodic Reports, Investment Company Act 
Release No. 26068 (June 5, 2003) (amending rule 30a-3). See also 
Certification of Disclosure in Companies' Quarterly and Annual 
Reports, Investment Company Act Release No. 25722 (Aug. 30, 2002) 
(adopting Exchange Act rules 13a-15 and 15d-15 to require that 
certain Exchange Act filers have disclosure controls and procedures 
in order ``to assist principal executive and financial officers in 
the discharge of their responsibilities in making the required 
certifications, as well as to discharge their responsibilities in 
providing accurate and complete information to security holders'').
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    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:
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    \26\ 17 CFR 270.38a-1 and 17 CFR 275.206(4)-7. See also 
Compliance Programs of Investment Companies and Investment Advisers, 
Investment Company Act Release No. 26299 (Dec. 17, 2003) 
(``Compliance Rules Adopting Release'').
    \27\ Investment Company Act rule 38a-1 provides that the 
policies and procedures must be reasonably designed to prevent 
violations of the federal securities laws (as defined in the rule), 
and Advisers Act rule 206(4)-7 provides that the policies and 
procedures must be reasonably designed to prevent violations of the 
Advisers Act and the rules thereunder.
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    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\
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    \28\ Compliance Rules Adopting Release, supra footnote 26, at 
section II.A.2.c.
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    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\
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    \29\ The FASB issued Fair Value Measurements, Statement of 
Financial Accounting Standards No. 157 (``SFAS No. 157''), in 
September 2006, and codified it in 2009 as ASC Topic 820.
    \30\ See supra footnote 13 (describing the difference between 
what ``fair value'' means under the Investment Company Act and under 
ASC Topic 820).
    \31\ Id. Rule 4-01(a)(1) of Regulation S-X [17 CFR 210.4-
01(a)(1)] states that ``[f]inancial statements filed with the 
Commission which are not prepared in accordance with generally 
accepted accounting principles will be presumed to be misleading or 
inaccurate, despite footnote or other disclosures, unless the 
Commission has otherwise provided.''
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    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.
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    \32\ The rule would define ``fund'' as a registered investment 
company or a business development company. Proposed rule 2a-5(e)(1).
    \33\ For purpose of the proposed rule, ``board'' means 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. Proposed rule 2a-5(e)(3).
---------------------------------------------------------------------------

    Accordingly, under the proposed rule, fair value as determined in 
good faith would require assessing and managing

[[Page 28738]]

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\
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    \34\ Proposed rule 2a-5(a).
    \35\ Proposed rule 2a-5(b).
---------------------------------------------------------------------------

    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\
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    \36\ An open-end fund is a management investment company that 
offers for sale or has outstanding redeemable securities of which it 
is the issuer. See section 5(a)(1) of the Investment Company Act. A 
closed-end fund is a management investment company other than an 
open-end fund. See section 5(a)(2) of the Investment Company Act. 
Section 2(a)(48) of the Investment Company Act defines a ``business 
development company'' as any closed-end investment company that 
operates for the purpose of making investments in securities 
described in section 55(a)(1) through 55(a)(3) of the Investment 
Company Act and that makes available significant managerial 
assistance with respect to the issuers of such securities.
    \37\ See proposed rule 2a-5(e)(1) (defining ``fund'' to mean a 
registered investment company or business development company).
    \38\ Proposed rule 2a-5(d). Section 4(2) of the Investment 
Company Act defines a UIT as an investment company that (1) is 
organized under a trust indenture or similar instrument, (2) does 
not have a board of directors, and (3) issues only redeemable 
securities, each of which represents an undivided interest in a unit 
of specified securities. But see Form N-7 for Registration of Unit 
Investment Trusts under the Securities Act of 1933 and the 
Investment Company Act of 1940, Investment Company Act Release No. 
15612, Appendix B, Guide 2, [52 FR 8268, 8295-96 (Mar. 17, 1987)] 
(Staff Guidelines stating that the board's fair value role under 
section 2(a)(41) is to be performed by the UIT's trustee or the 
trustee's appointed person). See infra section II.D (rescission of 
staff guidance).
---------------------------------------------------------------------------

    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\
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    \39\ The staff's review will include, but will not necessarily 
be limited to, the letters identified in that section.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \40\ These requirements would apply to a fund's board that is 
determining fair value or, if the board assigns any fair value 
determinations to an adviser as discussed below, to that adviser.
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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.
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    \41\ Proposed rule 2a-5(a)(1). Valuation risk includes the risks 
associated with the process of determining whether an investment 
must be fair valued in the first place.
---------------------------------------------------------------------------

    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\
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    \42\ Potential indicators of market or sector shocks or 
dislocations could include a significant change in short-term 
volatility or market liquidity, significant changes in trading 
volume, or a sudden increase in trading suspensions.
---------------------------------------------------------------------------

     the extent to which each fair value methodology uses 
unobservable inputs, particularly if such inputs are provided by the 
adviser; \43\
---------------------------------------------------------------------------

    \43\ See infra footnotes 209-210 and accompanying text.
---------------------------------------------------------------------------

     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

[[Page 28739]]

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.
---------------------------------------------------------------------------

    \44\ ASC Topic 820 refers to valuation approaches and valuation 
techniques. In practice, many valuation techniques are referred to 
as methods (e.g., discounted cash flow method). As a result, this 
release uses the terms ``technique'' and ``method'' interchangeably 
to refer to a specific way of determining fair value and likewise 
uses the terms ``methods'' and ``methodologies'' interchangeably.
    \45\ Proposed rule 2a-5(a)(2). Regarding the key inputs and 
assumptions specific to each asset class or portfolio holding, it 
would not be sufficient, for example, to simply state that private 
equity investments are valued using a discounted cash flow model, or 
that options are valued using a Black-Scholes model, without 
providing any additional detail on the specific qualitative and 
quantitative factors to be considered, the sources of the 
methodology's inputs and assumptions, and a description of how the 
calculation is to be performed (which may, but need not necessarily, 
take the form of a formula).
    \46\ Different methodologies may be appropriate for different 
asset classes. Accordingly, this requirement would not require that 
a single methodology be applied in all cases, but instead that any 
methodologies selected be applied consistently to the asset classes 
for which they are relevant.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \47\ See supra footnote 44.
    \48\ See ASR 118 (``Methods which are in accord with this 
principle may, for example, be based on a multiple of earnings, or a 
discount from market of a similar freely traded security, or yield 
to maturity with respect to debt issues, or a combination of these 
and other methods.''). Consistent with the principles in ASC Topic 
820, under the proposal, the methodologies selected should maximize 
the use of relevant observable inputs and minimize the use of 
unobservable inputs.
---------------------------------------------------------------------------

    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\
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    \49\ Proposed rule 2a-5(a)(2)(i). For example, the board or 
adviser, as applicable, generally should address, prior to the 
fund's investing in a new type of investment, whether readily 
available market quotations will be used or if the investment may 
need to be fair valued on occasion or at all times. For certain 
types of investments, it should be clear that the asset will require 
a fair value at all times. For others, however, market quotations 
may sometimes be readily available and sometimes not, so that 
periodically a fair value will need to be determined. The board or 
adviser generally should seek to identify sources of price inputs 
before the fund invests in such asset classes, if possible, in 
addition to determining an appropriate fair value methodology, and 
generally should document these decisions.
    \50\ Proposed rule 2a-5(a)(2)(ii). ASC Topic 820-10-35-25 
provides a non-exhaustive list of events that may warrant a change 
or an adjustment to a valuation technique, including where (1) new 
markets develop, (2) new information becomes available, (3) 
information previously used is no longer available, (4) the 
valuation technique improves, and (5) market conditions change. 
Boards or advisers generally should seek to account for such 
occurrences and consider specifying alternative sources.
    \51\ See ASC Topic 820-10-35-25.
    \52\ Records supporting any such methodology changes would be 
required to be maintained under the proposed recordkeeping 
provisions. See proposed Rule 2a-5(a)(6).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \53\ Proposed rule 2a-5(a)(2)(iii). As discussed below, we are 
also proposing to define when market quotations are readily 
available for purposes of section 2(a)(41).
    \54\ Proposed rule 2a-5(a)(2)(iv).
    \55\ See ASC Topic 820-10-35-41C(b).
---------------------------------------------------------------------------

    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

[[Page 28740]]

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\
---------------------------------------------------------------------------

    \56\ Proposed rule 2a-5(a)(3).
    \57\ Id. Calibration can assist in assessing whether the fund's 
valuation technique reflects current market conditions, and also 
whether any adjustments to the valuation technique are appropriate. 
``Calibration'' for these purposes is the process for monitoring and 
evaluating whether there are material differences between the actual 
price the fund paid to acquire portfolio holdings that received a 
fair value under the Act and the prices calculated for those 
holdings by the fund's fair value methodology at the time of 
acquisition.
    \58\ Back-testing involves a comparison of the fair value 
ascribed to the fund's investment against observed transactions or 
other market information, such as quotes from dealers or data from 
pricing services. One common form of back-testing is ``disposition 
analysis,'' which compares a fair value as determined using a fair 
value technique with the price obtained for the security upon its 
disposition by the fund.
    \59\ See In re Morgan Asset Management, supra footnote 9 (back-
testing by the fund ``only covered securities after they were sold; 
thus, at any given time, the Valuation Committee never knew how many 
securities' prices could ultimately be validated by it.'').
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \60\ See 2014 Money Market Fund Release, supra footnote 14, at 
section III.D.2.b.
    \61\ Proposed rule 2a-5(a)(4).
---------------------------------------------------------------------------

    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.
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    \62\ In considering a pricing service's valuation methods or 
techniques, inputs, and assumptions, the fair value policies and 
procedures generally should address whether the pricing service is 
relying on inputs or assumptions provided by the adviser.
    \63\ Price challenges involve, for example, the fund disagreeing 
with an evaluated price provided by a pricing service and providing 
additional information to the service suggesting that the provided 
evaluated price is not correct.
---------------------------------------------------------------------------

    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

[[Page 28741]]

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\
---------------------------------------------------------------------------

    \64\ Proposed rule 2a-5(a)(5).
    \65\ Proposed rule 2a-5(b).
---------------------------------------------------------------------------

    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.
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    \66\ Rule 38a-1(a)(2).
    \67\ For UITs, the fund's principal underwriter or depositor 
conducts the functions assigned to management company boards under 
rule 38a-1. Rule 38a-1(b). This would continue if we adopt the 
proposed rule.
    \68\ See rule 38a-1(a)(4)(iii)(A). See also Compliance Rules 
Adopting Release, supra footnote 26, at n.33. ``Material'' in this 
context is a change that a fund director would reasonably need to 
know in order to oversee fund compliance. See rule 38a-1(e)(2). We 
have also said that ``serious compliance issues'' must be raised 
with the board immediately. See Compliance Rules Adopting Release, 
supra footnote 26, at n.33.
    \69\ If adopted, rule 2a-5's requirements would supersede the 
Compliance Rules Adopting Release's discussion of specific policies 
and procedures required regarding the pricing of portfolio 
securities and fund shares. Cf. Compliance Rules Adopting Release, 
supra footnote 26, at nn.39-47 and accompanying text.
    \70\ See generally footnote 108.
---------------------------------------------------------------------------

    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:
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    \71\ Proposed rule 2a-5(a)(6). Under the proposed rule, the fund 
would maintain the required records both where the board itself 
determines the fair value of investments and where it assigns fair 
value determinations to an adviser under proposed rule 2a-5(b), as 
discussed at infra section II.B.6.
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     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\
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    \72\ Rule 38a-1(d) requires the maintenance of certain records, 
including copies of: All compliance policies and procedures adopted 
by the fund that are in effect or were in effect at any time during 
the last five years; materials provided to the board in connection 
with their approval of fund and service provider policies and 
procedures under the rule; the CCO's annual report to the board; and 
any records documenting the board's annual review of fund and 
service provider compliance policies and procedures under the rule. 
Rule 204-2 under the Advisers Act similarly requires an adviser to 
maintain copies of the adviser's compliance policies and procedures 
that are in effect or were in effect at any time during the last 
five years and any records documenting its annual review of such 
policies and procedures. See 17 CFR 275.204-2. See also Compliance 
Rules Adopting Release, supra footnote 26, at section II.D. The 
funds' and advisers' records may be retained electronically. See id. 
(discussing rule 31a-2(f) under the Investment Company Act and rule 
204-2(g) under the Advisers Act).
     Other provisions of the federal securities laws require, among 
other things, that registered investment companies maintain 
appropriate books and records in support of the fund's financial 
statements and preserve for a specified period (generally six years) 
all schedules evidencing and supporting each computation of NAV. See 
Investment Company Act section 31(a) and rules 31a-1 and 31a-2. In 
addition, funds reporting under the Exchange Act must make and keep 
books, records, and accounts that accurately and fairly reflect 
their transactions and dispositions of their assets in reasonable 
detail. 15 U.S.C. 78m(b)(2)(A).
    \73\ See In re Allied Capital Corp., Securities Exchange Act 
Release No. 55931 (June 20, 2007) (settlement) (fund failed to 
maintain documentation required under the Exchange Act). See also In 
the Matter of Carroll A. Wallace, Securities Exchange Act Release 
No. 48372 (Aug. 20, 2003) (Commission opinion) (partner of 
accounting firm engaged in improper professional conduct in 
recklessly failing to obtain sufficient competent evidential 
material to support statements in the auditors' reports); In the 
Matter of Morgan Stanley, Securities Exchange Act Release No. 50632 
(Nov. 4, 2004) (settlement) (financial services firm failed to 
maintain sufficient underlying documentation supporting certain 
valuations).
---------------------------------------------------------------------------

    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\
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    \74\ Stale price analysis can include an evaluation of whether a 
price quote that may be used to support a fair value price is 
sufficiently timely to be useful.
    \75\ Proposed rule 2a-5(a)(6)(i).
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    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.
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    \76\ See supra footnote 72.
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    We request comment on the proposed recordkeeping provisions.

[[Page 28742]]

    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.
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    \77\ Section 2(a)(41)(B)(ii) provides that, when market 
quotations are not readily available, ``value'' means ``fair value 
as determined in good faith by the board of directors.'' Rule 2a-4 
contains the same definition of fair value as section 
2(a)(41)(B)(ii). 17 CFR 270.2a-4. The Commission has discussed the 
board's role in determinations of fair value in a number of 
Commission releases, including ASR 113, ASR 118, the Compliance 
Rules Adopting Release, supra footnote 26, and the 2014 Money Market 
Fund Release, supra footnote 14.
     In addition to their role under the Act, boards may have 
liability under antifraud provisions of the federal securities laws 
if a fund's prospectus or other disclosures regarding valuation are 
not consistent with the fund's valuation practices. See, e.g., 15 
U.S.C. 77k(a)(1).
    \78\ See, e.g., 2014 Money Market Fund Release, supra footnote 
14, at nn.890 and 896 and accompanying text; In the Matter of 
Seaboard Associates, Inc. (Report of Investigation Pursuant to 
Section 21(a) of the Exchange Act), Investment Company Act Release 
No. 13890 (Apr. 16, 1984) (``The Commission wishes to emphasize that 
the directors of a registered investment company may not delegate to 
others the ultimate responsibility of determining the fair value of 
any asset not having a readily ascertainable market value, such as 
oil and gas royalty interests.'').
    \79\ The Commission stated in ASR 118 that the board ``may 
appoint persons to assist them in the determination of [fair] value, 
and to make the actual calculations pursuant to the board's 
direction''; however, ``the findings of such individuals must be 
carefully reviewed by the directors in order to satisfy themselves 
that the resulting valuations are fair.'' See also ASR 113 (``The 
actual calculations may be made by persons acting pursuant to the 
direction of the board.'').
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    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\
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    \80\ As discussed above, in this circumstance, the fund would, 
on behalf of the board, adopt and implement policies and procedures 
and keep records consistent with the requirements of paragraph (a) 
of the proposed rule. See proposed rule 2a-5(b).
    \81\ For example, for a fund that issues redeemable securities, 
value must be calculated at least once each business day for each 
portfolio holding in order to calculate the fund's NAV. 17 CFR 
270.22c-1(b)(1). Making these fair value determinations by 
themselves would therefore likely be impracticable for most, if not 
all, boards of such funds.
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    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.
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    \82\ As noted above, because a UIT does not have a board of 
directors or an investment adviser, a UIT's trustee would conduct 
fair value determinations under the proposed rule. See proposed rule 
2a-5(d). See also supra footnote 38.
    \83\ See rule 38a-1. These challenges include, for example, how 
to address reconciling differing opinions on the same investment (if 
applicable) and establishing clear reporting structures.
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    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?

[[Page 28743]]

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\
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    \84\ See generally Investment Company Governance, Investment 
Company Act Release No. 26520 (July 27, 2004) (``Governance 
Release'').
    \85\ See, e.g., Derivatives Release, supra footnote 17, at 
section II.C.
    \86\ Proposed rule 2a-5(b)(1).
    \87\ For example, we have stated that independent directors 
should ``bring to the boardroom `a high degree of rigor and 
skeptical objectivity to the evaluation of management and its plans 
and proposals,' particularly when evaluating conflicts of 
interest.'' See Governance Release, supra footnote 84.
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    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\
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    \88\ For a discussion of fund fair value risks generally, see 
supra section II.A.1.
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    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.
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    \89\ See, e.g., Governance Release, supra footnote 87 (`` . . . 
state law duties of loyalty and care . . . oblige directors to act 
in the best interest of the fund when considering important matters 
the Act entrusts to them, such as approval of an advisory contract 
and the advisory fee.'').
    \90\ See, e.g., id. (``. . . the Act and our rules rely heavily 
on fund boards of directors to manage the conflicts of interest that 
advisers have with funds they manage.''). See also Division of 
Investment Management, SEC, Protecting Investors: A Half Century of 
Investment Company Regulation, 252 (1992) (``the [Investment 
Company] Act . . . imposes requirements that assume the standard 
equipment of a corporate democracy: a board of directors . . . whose 
function is to oversee the operations of the investment company and 
police conflicts of interest. . . [W]e believe that independent 
directors perform best when required to exercise their judgment in 
conflict of interest situations''); see also Investment Company 
Institute Independent Directors Council, Fair Valuation Series: The 
Role of the Board at 10 (2006) (``IDC Role of the Board''), 
available at http://www.ici.org/pdf/06_fair_valuation_board.pdf 
(``Investment professionals, for example, can be important sources 
of information about the value of securities. At the same time, 
conflict of interest concerns may be raised when investment 
professionals assign fair valuations that dramatically boost a 
fund's performance. These concerns may be heightened when the 
compensation of the investment professionals is based on the fund's 
performance. To address these potential concerns, boards may want to 
consider whether investment professionals responsible for managing a 
particular fund should have sole or primary authority for 
determining securities valuations for that fund.'').
    \91\ See, e.g., Piper, supra footnote 7. For conflicts of the 
fund's portfolio manager, see infra footnote 120 and accompanying 
text.
    \92\ Cf. In re Morgan Asset Management, supra footnote 9, at 7 
(broker-dealer ``induced to provide interim price confirmations that 
were lower than the values at which the Funds were valuing certain 
bonds, but higher than the initial confirmations that the [broker-
dealer] had intended to provide'').
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    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.
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    \93\ See In re Morgan Asset Management, supra footnote 9 (``the 
Valuation Committee left pricing decisions to lower level employees 
in Fund Accounting who did not have the training or qualifications 
to make fair value pricing determinations'').
---------------------------------------------------------------------------

    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\
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    \94\ Proposed rule 2a-5(b)(1)(ii).
---------------------------------------------------------------------------

    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?

[[Page 28744]]

    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?
---------------------------------------------------------------------------

    \95\ See supra footnote 33.
    \96\ Proposed rule 2a-5(e)(3).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \97\ See ``Practical Guidance for Fund Directors on Valuation 
Oversight,'' Report of the Mutual Fund Directors Forum (June 2012) 
(available at https://mfdf.org/images/Newsroom/Valuation-web.pdf) 
(``MFDF Valuation Report'') at 14-15.
    \98\ This would be in addition to any reports required under 
rule 38a-1. See Compliance Rules Adopting Release, supra footnote 
26, at section II.A.2.c.
    \99\ The requirements we propose in this document would be 
minimum requirements and fund boards could always ask for additional 
reporting from advisers. See infra footnote 110 and accompanying 
text.
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    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,

[[Page 28745]]

graphical representations, statistical analyses, dashboards, or 
exceptions-based reporting, among other methods.
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    \100\ Proposed rule 2a-5(b)(1). This is similar to the approach 
we have adopted with regard to money market stress testing and 
proposed with regard to board oversight of derivatives risk 
managers. See 2014 Money Market Fund Release, supra footnote 14, and 
Derivatives Release, supra footnote 17.
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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:
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    \101\ Proposed rule 2a-5(b)(1)(i).
    \102\ See MFDF Valuation Report, supra footnote 97, at 14.
    \103\ Fund boards could always request additional information if 
they so choose. Proposed rule 2a-5(b)(1)(i)(F).
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     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.
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    \104\ Proposed rule 2a-5(b)(1)(i)(A). See supra section II.A.1 
discussing this process. For example, the adviser could discuss 
instances where it challenged the pricing information provided by an 
affiliated or third party vendor.
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     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.
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    \105\ Proposed rule 2a-5(b)(1)(i)(B). For example, a report 
could discuss when key inputs or assumptions are changed and the 
reasons for the changes. We believe that both a material change and 
the reason for it would be information that may be reasonably 
necessary for the board to evaluate such changes.
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     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.
---------------------------------------------------------------------------

    \106\ Proposed rule 2a-5(b)(1)(i)(C).
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     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.
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    \107\ Proposed rule 2a-5(b)(1)(i)(D). For example, an adviser 
should disclose to the board when the adviser seeks to hire a new 
pricing service to cover a new asset type or when replacing a person 
with a background in valuation with a person without that background 
in a position of authority regarding the adviser's fair value 
process. See also proposed rule 2a-5(b)(2).
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     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.
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    \108\ If the board assigns the fair value determination to an 
adviser under the proposed rule, the board would generally be aware 
of an adviser initially appointing, and the establishment of the 
process for overseeing, a pricing service as part of its oversight 
and approval of the adviser's policies and procedures under rule 
38a-1. As a result, we are not specifically proposing to require 
that information be included in these periodic reports.
    \109\ Proposed rule 2a-5(b)(1)(i)(E). There may be times when 
pricing information from a pricing vendor differs materially from 
the adviser's view of the then-current fair value of the portfolio 
holding, and the adviser may seek to contact the pricing vendor to 
question the basis for the pricing information. Because this 
difference in pricing suggests that further inquiry is needed to 
assess the adequacy of the fair value process when these conflicts 
occur, we are proposing to require this reporting.
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \110\ Proposed rule 2a-5(b)(1)(i)(F).
---------------------------------------------------------------------------

    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:
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    \111\ Boards and fund CCOs may also consider requesting or 
including items such as the examples given in the bullet list below, 
if relevant, as part of the CCO's annual reports to the board under 
rule 38a-1(a)(4)(iii).
---------------------------------------------------------------------------

     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\
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    \112\ See supra footnote 57. In these cases, reports on back-
testing could indicate whether fair value is being compared to 
actual sales prices or to pricing information from pricing services 
and dealers. In the latter case, the reports could state whether 
dealer prices are actual bids or firm commitments or are indicative 
or accommodation quotes that merely represent the opinion of the 
dealer.
---------------------------------------------------------------------------

     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

[[Page 28746]]

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.
---------------------------------------------------------------------------

    \113\ For example, a significant increase in price challenges or 
overrides likely would reflect a material change to the fund's 
valuation risks that should be promptly reported to the board,
    \114\ Proposed rule 2a-5(b)(1)(ii).
---------------------------------------------------------------------------

    ``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.
---------------------------------------------------------------------------

    \115\ See PCAOB AS 2201 An Audit of Internal Control Over 
Financial Reporting That is Integrated with An Audit of Financial 
Statements, Appendix A--Definitions .A7 (defining ``material 
weakness'' and ``reasonable possibility''). See also Sarbanes-Oxley 
Act, supra footnote 21, at Title III Sec. 302(a)(5).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \116\ Id.
---------------------------------------------------------------------------

    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

[[Page 28747]]

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\
---------------------------------------------------------------------------

    \117\ Proposed rule 2a-5(b)(2).
    \118\ See also proposed rule 2a-5(a)(4).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \119\ See In re Morgan Asset Management, supra footnote 9.
    \120\ Id. at 4 (fund's portfolio manager ``actively screened and 
influenced a broker-dealer to change the price confirmations [and] 
failed to advise . . . when he received information indicating that 
the Fund's prices for certain securities should be reduced.'').
    \121\ In addition, as the person most directly responsible for 
the fund's investments, the portfolio manager may also be concerned 
about the reputational or career implications of the fund's 
performance, or its compliance with investment limitations, which 
can provide an incentive to smooth returns or otherwise misvalue 
portfolio holdings.
---------------------------------------------------------------------------

    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

[[Page 28748]]

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.
---------------------------------------------------------------------------

    \122\ See Liquidity Risk Management Release, supra footnote 3, 
at section III.H.1.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \123\ Proposed rule 2a-5(b)(3).
    \124\ Proposed rule 2a-5(b)(3).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \125\ See supra section II.A.6.
    \126\ Proposed rule 2a-5(b)(3).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \127\ Section 2(a)(41).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \128\ We acknowledge that specific references and principles in 
U.S. GAAP may change over time. When referencing ASC Topic 820 
throughout this release, we intend to reference the accounting topic 
on Fair Value Measurements within U.S. GAAP and the principles 
therein.
---------------------------------------------------------------------------

    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

[[Page 28749]]

such circumstances, the fund would need to fair value the security.
---------------------------------------------------------------------------

    \129\ Proposed rule 2a-5(c). ASC Topic 820 defines level 1 
inputs as ``[q]uoted prices (unadjusted) in active markets for 
identical assets . . . that the reporting entity can access at the 
measurement date.'' ASC Topic 820-10-20 (emphasis added). In ASR 
113, the Commission interpreted ``readily available market 
quotations'' to refer ``to reports of current public quotations for 
securities similar in all respects to the securities in question.'' 
Despite the respective references to ``securities similar in all 
respects'' in the Commission's prior guidance and ``identical 
assets'' in ASC Topic 820, we view these respective definitions as 
being substantively the same.
    \130\ Proposed rule 2a-5(e)(2). See also supra section II.A.2.
    \131\ See ASC Topic 820-10-35-41C (outlining circumstances when 
a reporting entity shall make an adjustment to a Level 1 input).
    \132\ See id. at b.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \133\ See 2014 Money Market Fund Release supra footnote 14, at 
text accompanying n.895.
    \134\ See Liquidity Risk Management Release, supra footnote 3, 
at nn.800-801 and accompanying text.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \135\ See ASR 113 (``1. The Problems of Valuation'' and ``2. The 
Problems of Portfolio Management''); ASR 118. ASR 118 refers to the 
concepts of ``inclusion'' and ``valuation'' of securities in the 
portfolio, which we believe are equivalent to the U.S. GAAP concepts 
of recognition and measurement, respectively.
    \136\ See supra section I.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \137\ Rule 2a-4(a)(2) under the Investment Company Act provides 
that, for purposes of calculating the NAV of a redeemable security, 
``changes in holdings of portfolio securities shall be reflected no 
later than in the first calculation on the first business day 
following the trade date.'' The ``first business day following the 
trade date'' is commonly referred to as T+1. We believe that our 
proposed rescission of ASR 113 and ASR 118 is consistent with the 
provisions of rule 2a-4.
    \138\ See ASC 946-320-25-1.
    \139\ See ASC 946-320-25-2.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \140\ See ASC 946-320-35-1 and ASC 946-325-35-1.
    \141\ As noted above, the term ``fair value'' is used in 
sections II.A and II.B as defined in ASC Topic 820. See supra 
footnote 13.
    \142\ ASC Topic 820 defines fair value at ASC 820-10-20. See 
also ASC Topic 820-10-50.
---------------------------------------------------------------------------

    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

[[Page 28750]]

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\
---------------------------------------------------------------------------

    \143\ See Rule 4-01(a)(1) of Regulation S-X [17 CFR 210.4-
01(a)(1)]. See also ASR 150 (Dec. 20, 1973) and ASR 4 (Apr. 25, 
1938).
    \144\ Policy Statement: Reaffirming the Status of the FASB as a 
Designated Private-Sector Standard Setter, Investment Company Act 
Release No. 26028 (Apr. 25, 2003) [68 FR 23333 (May 1, 2003)] (``FR-
70'').
    \145\ 15 U.S.C 77s(b).
    \146\ See FR-70, supra footnote 144; rule 4-01(a)(1) of 
Regulation S-X.
    \147\ In ASR 118 the Commission stated that, as a general 
principle, fair value of a security would be the amount that a fund 
might reasonably expect to receive for the security upon its current 
sale. (The ``current sale'' standard also is referred to as the 
``exit price'' standard.) In U.S. GAAP, ASC Topic 820 defines fair 
value as the price that would be received to sell an asset or paid 
to transfer a liability between market participants at the 
measurement date under current market conditions (an exit price).
    \148\ We also are proposing to make conforming amendments to 17 
CFR 210.6-03 (rule 6-03 of Regulation S-X).
    \149\ The proposed rescission would eliminate the Commission's 
auditing guidance to verify all quotations of securities with 
readily available market quotations at the balance sheet date, 
implicating the auditor's requirement to test the valuation 
assertion for all securities. This proposal does not impact the 
statutory requirement in section 30(g) of the Investment Company 
Act, which requires the independent public accountant to verify 
securities owned, either by actual examinations, or by receipt of a 
certificate from the custodian, which implicates the auditor's 
requirement to test the existence assertion for all securities. The 
statutory requirement under section 30(g) of the Investment Company 
Act remains distinct from the requirements in auditing standards 
established by the PCAOB.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \150\ The discussion of liquidity in ASR 113 under the heading 
``2. The Problems of Portfolio Management'' has been rendered moot 
by the adoption of rule 22e-4 on liquidity risk management programs. 
The discussion in ASR 113 under the heading ``3. The Problem of 
Disclosure'' has been rendered obsolete by the repeal of Form N-8B-1 
and the adoption of our current disclosure forms. See, e.g., 
Investment Company Registration and Report Forms and Reporting 
Requirements, Revision of Forms, Reports and Regulations, Investment 
Company Act Release No. 10378 (Aug. 28, 1978) (``Forms N-1 and N-2 . 
. . replace Form N-8B-1''); Registration Form Used by Open-End 
Management Investment Companies; Guidelines, Investment Company Act 
Release No. 13436 (Aug. 22, 1983) (Form N-1A replaces Form N-1); 
Form N-1A; Form N-2.
    \151\ See also ASR 113.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \152\ See 2014 Money Market Fund Release supra footnote 14. See 
also Accounting Series Release No. 219, Valuation of Debt 
Instruments by Money Market Funds and Certain Other Open-End 
Investment Companies, (May 31, 1977) (stating that, under certain 
circumstances, funds may determine the fair value of debt securities 
that mature in 60 days or fewer by using the amortized cost method).
---------------------------------------------------------------------------

    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?
---------------------------------------------------------------------------

    \153\ ASR 118.
---------------------------------------------------------------------------

    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?
---------------------------------------------------------------------------

    \154\ See 2014 Money Market Fund Release, supra footnote 14. 
These views were codified in the ``Codification of Financial 
Reporting Policies'' at section 404.05.c.
---------------------------------------------------------------------------

    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.

[[Page 28751]]



------------------------------------------------------------------------
             Name                      Date                Topic
------------------------------------------------------------------------
Paul Revere Investors, Inc....  Feb. 21, 1973....  Delegation to a board
                                                    valuation committee.
The Putnam Growth Fund and      Jan. 23, 1981....  Fair value of
 Putnam International Equities                      portfolio securities
 Fund, Inc..                                        which trade on a
                                                    closed foreign
                                                    exchange.
Form N-7 for Registration of    Mar. 17, 1987....  Fair value for UITs
 Unit Investment Trusts under                       to be determined by
 the Securities Act of 1933                         the trustee or its
 and the Investment Company                         appointed person.
 Act of 1940, Investment
 Company Act Release No.
 15612, Appendix B, Guide 2.
Investment Company Institute..  Dec. 8, 1999.....  Fair value generally.
Investment Company Institute..  Apr. 30, 2001....  Fair value generally.
Valuation Guidance Frequently   2014.............  Fund directors'
 Asked Questions (FAQ 1 only).                      responsibilities
                                                    when determining
                                                    whether an evaluated
                                                    price provided by a
                                                    pricing service, or
                                                    some other price,
                                                    constitutes fair
                                                    value.
------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \155\ See proposed rule 2a-5(a).
    \156\ See proposed rule 2a-5(b).
    \157\ See proposed rule 2a-5(c).
    \158\ Our analysis of the proposed rule takes into account the 
rescission of ASR 113 and ASR 118 as well as the withdrawal and 
rescission of certain staff letters and other guidance addressing a 
board's determination of fair value and other matters covered by 
proposed rule 2a-5 (see Sections II.D. and II.E. above).
---------------------------------------------------------------------------

    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

[[Page 28752]]

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\
---------------------------------------------------------------------------

    \159\ See supra footnotes 1, 12, 14, and 26. See also Section I 
for a discussion of other aspects of funds' regulatory framework 
that are related to boards' fair value role (e.g., the Sarbanes-
Oxley Act and ASC Topic 820).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \160\ See supra footnote 14.
    \161\ See supra footnote 15.
    \162\ ASR 118 supra footnote 16.
    \163\ 2014 Money Market Fund Release, supra footnote 14.
    \164\ Id.
    \165\ Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \166\ Compliance Rules Adopting Release, supra footnote 26, at 
74718.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \167\ See, e.g., Investment Company Institute, Independent 
Directors Council, ICI Mutual Insurance Company, The Role of the 
Board, Spring 2005 (``ICI and IDC Report''); K&L Gates, Mutual Fund 
Valuation and Liquidity Procedures, 2013 (``K&L Report''); K&L 
Gates, Mutual Fund Pricing and Fair Valuation, 2016; MFDF Valuation 
Report, see supra footnote 97.
    \168\ See, e.g., ICI and IDC Report, supra footnote 167, at 6-7.
    \169\ Funds have discretion in the type of disclosures they 
provide regarding their fair value determinations. Our review of N-
1A, 485APOS, 485BPOS, N-2, and POS 8C Forms filed with the 
Commission between January 1, 2019 and December 31, 2019 showed that 
only 13% of the open-end funds and closed-end funds disclose 
information related to board's fair value practices, out of which 
37% explicitly state that the investment adviser assists the board 
in the fair value determinations. Nevertheless, the results of our 
review should be interpreted with caution because funds' disclosures 
of fair value practices are unstructured and results may be 
sensitive to the algorithm used to identify those disclosures.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \170\ See, e.g., Investment Company Institute, Independent 
Directors Council, ICI Mutual Insurance Company, An Introduction to 
Fair Valuation, Spring 2005 (``ICI Fair Valuation Report''), at 7. 
Nevertheless, ``[t]here may be circumstances at a particular fund 
group that leads a board and adviser to determine that it is 
desirable for an independent director to be involved in day-to-day 
decision-making, whether as part of the adviser's valuation 
committee or by reviewing and ratifying the committee's decisions 
daily.'' See MFDF Valuation Report, supra footnote 97, at 9.
    \171\ See, e.g., MFDF Valuation Report, supra footnote 97, at 4.
    \172\ See, e.g., K&L Report, supra footnote 167, at 14; MFDF 
Valuation Report, supra footnote 97, at 11.
---------------------------------------------------------------------------

    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

[[Page 28753]]

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\
---------------------------------------------------------------------------

    \173\ See, e.g., MFDF Valuation Report, supra footnote 97, at 6-
8; Deloitte Insights, 2019. Fair valuation pricing survey, 17th 
edition, executive summary (``Deloitte Survey''), at 10. We lack 
information on how the Deloitte survey sample was constructed or how 
the survey data was collected and so we cannot speak to the 
representativeness of the sample or the unbiasedness of the survey 
responses. Nevertheless, the results of the survey are largely 
consistent with the Commission staff's experience and in line with 
practices as described in prior Commission staff's letters. See, 
e.g., staff letters in Section II.E.
    \174\ See, e.g., MFDF Valuation Report, supra footnote 97, at 6-
8.
    \175\ According to a Deloitte survey, ``22 percent of survey 
participants noted that their boards seek to identify areas in the 
valuation process where there might be a conflict of interest and 
provide oversight relative to these conflicts.'' See Deloitte 
Survey, supra footnote 173, at 10. The cited statistic does not 
imply that the remaining funds do not have policies in place to 
manage conflicts of interest of investment advisers but it means 
that any such policies may not be valuation specific.
    \176\ See, e.g., MFDF Valuation Report, supra footnote 97, at 9.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \177\ See, e.g., MFDF Valuation Report, supra footnote 97, at 8.
    \178\ According to a Deloitte Survey, 34% of survey participants 
reported that the board or one of its subcommittees met with the 
chief risk officer or members of the risk committee to discuss 
valuation matters. See Deloitte Survey, supra footnote 173, at 10.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \179\ See, e.g., ICI and IDC Report, supra footnote 167, at 6-7; 
MFDF Valuation Report, supra footnote 97, at 5.
    \180\ See, e.g., MFDF Valuation Report, supra footnote 97, at 5.
    \181\ According to the Deloitte survey, 72% of survey 
participants performed periodic reviews of valuation models relating 
to private equity investments to determine the appropriateness and 
accuracy relative to the investment being valued, and 56% of 
participants reported that the valuation models used for private 
equity investments are explicitly subject to internal control 
policies and procedures. According to the same survey, 63% of survey 
participants made a change or revision to their valuation policies 
over the last year. See Deloitte Survey, supra footnote 173, p. 9 
and 14.
    \182\ See, e.g., MFDF Valuation Report, supra footnote 97, at 5.
    \183\ See, e.g., ICI and IDC Report, supra footnote 167, at 6-7 
and 10-11; MFDF Valuation Report, supra footnote 97, at 5.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \184\ See, e.g., ICI Fair Valuation Report, supra footnote 170, 
at 17-18.
    \185\ See, e.g., ICI and IDC Report, supra footnote 167, at 6-
78.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \186\ See generally MFDF Valuation Report, supra footnote 97, at 
9; ICI and IDC Report, supra footnote 167, at 8-10.
    \187\ See, e.g., ICI and IDC Report, supra footnote 167, at 10.
    \188\ See, e.g., ICI and IDC Report, supra footnote 167, at 8-
10.
    \189\ See, e.g., ICI and IDC Report, supra footnote 167, at 7.
---------------------------------------------------------------------------

    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

[[Page 28754]]

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\
---------------------------------------------------------------------------

    \190\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
10; ICI and IDC Report, supra footnote 167, at 10-11.
    \191\ See, e.g., ICI and IDC Report, supra footnote 167, at 11.
    \192\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
10.
    \193\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
11.
    \194\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
11.
    \195\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
10-11.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \196\ See, e.g., ICI and IDC Report, supra footnote 167, at 12-
13.
    \197\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
10. See also Deloitte Survey, supra footnote 173, at 10, stating 
that 26% of the participants mentioned that the board held a 
valuation discussion in the prior 12 months with management outside 
of a regularly scheduled meeting to address a valuation matter or 
question.
    \198\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
14.
    \199\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
14.
    \200\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
14.
    \201\ See, e.g., ICI and IDC Report, supra footnote 167, at 12.
    \202\ See, e.g., ICI and IDC Report, supra footnote 167, at 12-
13.
    \203\ See, e.g., ICI and IDC Report, supra footnote 167, at 13. 
See also Deloitte Survey, supra footnote 173, at 10, noting that 74% 
of the participants in the 2019 survey reported that their boards 
receive price challenge information as part of the valuation 
reports.
    \204\ See, e.g., ICI and IDC Report, supra footnote 167, at 13.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \205\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
14.
    \206\ See, e.g., MFDF Valuation Report, supra footnote 97, at 
14.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \207\ We estimate the number of registered investment companies 
by reviewing the most recent filings of Forms N-CEN filed with the 
Commission as of January 2020. Open-end funds are series of trusts 
registered on Form N-1A. Closed-end funds are trusts registered on 
Form N-2. UITs are variable annuity separate accounts organized as 
UITs registered on Form N-4, variable life insurance separate 
accounts organized as UITs registered on Form N-6, or series, or 
classes of series, of trusts registered on Form N-8B-2. Separate 
accounts registered as management companies are trusts registered on 
Form N-3.
    \208\ Estimates of the number of BDCs and their net assets are 
based on a staff analysis of Form 10-K and Form 10-Q filings as of 
September 2019, which are the most recent available filings. Our 
estimates include BDCs that may be delinquent or have filed 
extensions for their filings, and they exclude 8 wholly-owned 
subsidiaries of other BDCs and feeder BDCs in master-feeder 
structures.

                Table 1--Descriptive Statistics for Funds
------------------------------------------------------------------------
                                                        Total net assets
                                          Number of      (in billion $)
                                         funds  (1)           (2)
------------------------------------------------------------------------
Open-end funds.......................          12,379             28,184
Closed-end funds.....................             666                301
UITs.................................             674              1,883
Management company separate accounts.              14                234
BDCs.................................              98                 64
                                      ----------------------------------
    Total............................          13,831             30,666
------------------------------------------------------------------------
Sources: Form 10-K; Form 10-Q; Form N-CEN


[[Page 28755]]

    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.
---------------------------------------------------------------------------

    \209\ According to ASC 820, assets and liabilities are 
classified as using Level 1, Level 2, or Level 3 inputs. Level 1 
inputs are ``quoted prices (unadjusted) in active markets for 
identical assets or liabilities that the reporting entity can assess 
at the measurement date.'' Level 2 inputs are ``inputs other than 
quoted prices included within Level 1 that are observable for the 
asset or liability, either directly or indirectly.'' Level 3 inputs 
are ``unobservable inputs for the asset and liability.'' See 
Financial Accounting Standards Board, Fair Value Measurement (Topic 
820).
    \210\ See proposed rule 2a-5(c). See also supra Section II.C.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \211\ UITs (other than the ETFs registered as UITs) and BDCs do 
not file Form N-PORT, and thus are excluded from Table 2.
    We estimate the statistics in Table 2 by reviewing the most 
recent filings of Forms N-PORT filed with the Commission as of 
January 2020. The average ratio of securities by fair value 
hierarchy (i.e., Columns 3 to 6 in Table 2) is retrieved from Item 
C.8 of Form N-PORT. Our analysis excludes funds with non-positive 
net assets and funds with total assets less than net assets because 
these observations are likely data errors. The Average Level 1, 
Level 2, and Level 3 Inputs is the average ratio of Level 1, Level 
2, or Level 3 long positions divided by the fund's total gross 
assets across all funds within each fund category. Open-end funds 
are series of trusts registered on Form N-1A. Closed-end funds are 
trusts registered on Form N-2. ETFs registered as UITs are series, 
or classes of series, of trusts registered on Form S-6. Separate 
accounts registered as management companies are trusts registered on 
Form N-3.
    The last row in Table 2 represents the sum of the previous rows 
within the same column for Columns 1 and 2, and it represents the 
asset-weighted average of the previous rows within the same column 
for columns 3 to 6.
    \212\ The number of open-end funds, closed-end funds, ETFs 
registered as UITs, and separate accounts registered as management 
companies that filed Form N-PORT (i.e., 11,436 in Table 2) is 
smaller than the number of open-end funds, closed-end funds, ETFs 
registered as UITs, and separate accounts registered as management 
companies that filed Form N-CEN (i.e., 13,067 in Table 1) because, 
as of the N-PORT data collection date, N-PORT only covered large 
fund groups. Large fund groups are funds that together with other 
investment companies in the same ``group of related investment 
companies'' have net assets of $1 billion or more as of the end of 
the most recent fiscal year of the fund. Filing Form N-PORT will 
begin in April 2020 for small fund groups. See Amendments to the 
Timing Requirements for Filing Reports on Form N-PORT, Interim Final 
Rule, Release No. IC-33384; File No. S7-02-19. Nevertheless, large 
fund groups represent 84% of all open-end funds, closed-end funds, 
ETFs registered as UITs, and separate accounts registered as 
management companies in terms of total net assets (84% = $24,338 
billion total net assets in Table 2/$29,093 billion total net assets 
for open-end funds, closed-end funds, ETFs registered as UITs, and 
variable annuity separate accounts registered as management 
companies in Table 1).
    Total net assets in Form N-CEN also may be different than total 
net assets in Form N-PORT because Form N-CEN reports average net 
assets estimated over the reporting period while Form N-PORT reports 
point-in-time net assets as of the reporting date.
    \213\ Securities that are valued at NAV, and thus do not have a 
level associated with them, are classified as ``N/A'' in Form N-
PORT. These investments have no level under the U.S. GAAP fair value 
hierarchy and for purposes of this analysis we assume they are 
securities for which there are no readily available market 
quotations. Nevertheless, the valuation of those securities arguably 
requires less effort than the valuation of securities valued using 
Level 2 and 3 inputs because funds' NAVs are easily obtainable. 
About 1% of the fund assets are classified as ``N/A'' securities.
    The sum of the average using Level 1, 2, 3, and ``N/A'' within 
each fund category may not sum up to one hundred percent due to 
rounding error.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \214\ 28% = (3,209 open-end funds with securities valued using 
only Level 1 inputs that filed Form N-PORT + 29 closed-end funds 
with securities valued using only Level 1 inputs that filed Form N-
PORT + 5 ETFs registered as UITs with securities valued using only 
Level 1 inputs that filed Form N-PORT + 3 variable annuity separate 
accounts registered as management companies with securities valued 
using only Level 1 inputs that filed Form N-PORT)/11,436 funds that 
filed Form N-PORT. See supra footnote 211.
    \215\ 9,986 funds = 13,733 registered investment companies that 
filed Form N-CEN from Table 1 above-3,845 registered investment 
companies that filed Form N-CEN and are estimated to hold securities 
valued using only Level 1 inputs + 98 BDCs from Table 1 above. 3,845 
= 28% * 13,733 registered investment companies that filed Form N-CEN 
from Table 1 above. See supra footnote 214 for the estimation of the 
28%.
    This calculation assumes that the distribution of securities 
valued using Level 1 inputs for registered investment companies that 
filed Form N-PORT is similar to the distribution of securities 
valued using Level 1 inputs for registered investment companies that 
filed Form N-CEN. This calculation also assumes that all 98 BDCs in 
our sample hold a non-zero amount of securities valued using Level 2 
and Level 3 inputs because BDCs are required to invest at least 70% 
of their assets in private or public U.S. firms with market values 
of less than $250 million, and these investments usually are 
securities valued using Level 2 or Level 3 inputs. See 15 U.S.C. 
80a-54(a).
    Under the proposed rule 2a-5(d), if the fund is a unit 
investment trust, the fund's trustee must carry out the requirements 
related to fair value determinations. Hence, UITs would not bear 
one-time costs associated with oversight and reporting (see proposed 
rule 2a-5(b)) because the trustees of UITs would perform all fair 
value determinations. 9,501 = 9,986 affected fundsx485 affected 
UITs. 485 = 674 UITs that filed Form N-CEN - (1x28% of funds that 
only report securities valued using Level 1 inputs).

                                        Table 2--Descriptive Statistics for Funds by ASC 820 Fair Value Hierarchy
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                             Total net
                                                             Number of      assets  (in    Average level   Average level   Average level   Average ``N/
                                                               funds        billion $)       1 Inputs        2 Inputs        3 Inputs       A'' Inputs
                                                                     (1)             (2)             (3)             (4)             (5)             (6)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Open-end funds..........................................          10,841          23,429             63%             33%            0.2%              1%
Closed-end funds........................................             577             303             26%             60%              4%              9%
ETFs registered as UITs.................................               5             389             99%              0%              0%              0%

[[Page 28756]]

 
Management company separate accounts....................              13             217             73%             26%              0%              0%
                                                         -----------------------------------------------------------------------------------------------
        Total/Average...................................          11,436          24,338             63%             33%              0%              1%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Form N-PORT

    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\
---------------------------------------------------------------------------

    \216\ Based on Item 5.D. of Forms ADV filed with the Commission 
as of January 2020.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \217\ Investment Company Institute, 2019 Fact Book: A Review of 
Trends and Activities in the Investment Company Industry, available 
at https://www.ici.org/pdf/2019_factbook.pdf, accessed on December 
5, 2019.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \218\ See Section I above for more discussion on the importance 
of accurate and unbiased valuation of fund securities.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \219\ See section 2(a)(41) and rule 2a-4.
    \220\ See, e.g., MFDF Valuation Report, supra footnote 97, at 2.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \221\ Some academic literature suggests that fund fair values 
are not always measured in an accurate and unbiased way. See, e.g., 
Vikas Agarwal et al., Private Company Valuations by Mutual Funds, 
(Working Paper, 2019) available at https://ssrn.com/abstract=3066449; Rahul Bhargava et al., Exploiting International 
Stock Market Correlations with Open-End International Mutual Funds, 
25 J. Bus. Fin. & Acct. 765 (1998); Scott Cederburg & Neal 
Stoughton, Discretionary NAVs, (Working Paper, 2019) available at 
https://www.wu.ac.at/fileadmin/wu/d/i/finance/BBS-Papers/SS2019/20190515_STOUGHTON.pdf; John M. R. Chalmers et al., On the Perils of 
Financial Intermediaries Setting Security Prices: The Mutual Fund 
Wild Card Option, 56 J. Fin. 2209 (2001); Nandini Chandar & Robert 
Bricker, Incentives, Discretion, and Asset Valuation in Closed-End 
Mutual Funds, 40 J. Acct. Res., 1037 (2002) (``Chandar and Bricker 
2002''); Jaewon Choi et al., Sitting Bucks: Zero Returns in Fixed 
Income Funds, (Working Paper, 2019) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3244862; Cici et al. 
2011, supra footnote 7; Vladimir Atanasov et al., Mismarking Fraud 
in Mutual Funds, (Working Paper, 2019) available at http://www.fmaconferences.org/Glasgow/Papers/Fraud_in_OpenEndMutualFunds_2018_1126.pdf.
    \222\ See, e.g., Joseph Golec, Regulation and the Rise in Asset-
Based Mutual Fund Management Fees, 26 J. Fin. Res. 19 (2003) for 
evidence on the percentage of mutual funds that use asset-based 
management fees.
     In addition to explicit contracts that link investment 
advisers' compensation to fund size, there may be implicit contracts 
that provide incentives to investment advisers to mismeasure fund 
investments. For example, investment advisers may mismeasure fund 
investments to meet or beat certain benchmarks. See, e.g., Chandar 
and Bricker 2002, supra footnote 221.
    \223\ See, e.g., Judith Chevalier & Glenn Ellison, Risk Taking 
by Mutual Funds as a Response to Incentives, 105 J. Pol. Econ. 1167 
(1997); Erik R. Sirri & Peter Tufano, Costly Search and Mutual Fund 
Flows, 53 J. Fin. 53, 1589 (1998).
     Portfolio managers also have incentives to inflate fund asset 
values and thus increase fund performance because fund performance 
is positively related to the portfolio managers' compensation and 
negatively related to the probability that a portfolio manager will 
be terminated. See, e.g., Judith Chevalier & Glenn Ellison, Career 
Concerns of Mutual Fund Managers, 114 Q.J. Econ. 389 (1999); Linlin 
Ma et al., Portfolio Manager Compensation in the U.S. Mutual Fund 
Industry, 74 J. Fin. 587 (2018).
    \224\ See, e.g., Cici et al. 2011, supra footnote 7.
    \225\ Investment advisers may have incentives to underinvest in 
effort (or ``shirk'') because they do not internalize the benefits 
accruing to the fund board of directors and fund investors from the 
expenditure of effort to estimate accurate and unbiased fair values. 
See, e.g., David Brown & Shaun Davies, Moral hazard in asset 
management, 125 J. Fin. Econ. 311 (``Brown and Davies 2017'').
---------------------------------------------------------------------------

    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

[[Page 28757]]

and the other service providers involved in the calculations of fair 
values.\227\
---------------------------------------------------------------------------

    \226\ See, e.g., Brown and Davies 2017, supra footnote 225.
    \227\ See supra footnote 175.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \228\ See proposed rule 2a-5(a) and (b).
    \229\ Compare proposed rule 2a-5(a)(1)-(5) with Compliance Rules 
Adopting Release, supra footnote 26. See also supra footnote 28 and 
accompanying text.
    \230\ See proposed rule 2a-5(a)(2), (3), and (5).
    \231\ See rule 38a-1(d). See also supra footnote 72.
    \232\ See proposed rule 2a-5(a)(6) and (b)(3).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \233\ See supra Section III.B.1.
    \234\ See proposed rule 2a-5(b).
---------------------------------------------------------------------------

    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

[[Page 28758]]

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.
---------------------------------------------------------------------------

    \235\ The industry reports cited in Section III.B.2 above only 
provide qualitative information on certain aspects of funds' current 
practices. See also supra footnote 173 for a discussion of 
limitations of the Deloitte survey data. Finally, funds have 
discretion in the type of disclosures they provide regarding their 
fair value determinations. See supra footnote 169.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \236\ See proposed rule 2a-5(d).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \237\ Any such benefits could be at least partially limited by 
the fact that mandating specific fair value functions for all funds 
could lead to the adoption of fair value functions that are 
appropriate for most but not all funds.
    \238\ Nevertheless, we acknowledge that because the proposed 
rule is principles based, the possibility still exists that some 
funds may put in place additional policies and procedures, 
reporting, and recordkeeping that are not required by the proposed 
rule.
    \239\ Academic literature provides evidence consistent with the 
idea that uncertainty has negative effects on investment and growth. 
See, e.g., Nicholas Bloom et al., Uncertainty and Investment 
Dynamics, 74 Rev. Econ. Stud. 391 (2007); Nicholas Bloom, The Impact 
of Uncertainty Shocks, 77 Econometrica, 623 (2009); Scott R. Baker 
et al., Measuring Economic Policy Uncertainty, 131 Q. J. Econ. 1593 
(2016).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \240\ This benefit would not accrue to UITs because under the 
proposed rule the trustees of UITs would carry out the requirements 
of the proposed rule. See proposed rule 2a-5(d).
    \241\ See supra footnote 235.
---------------------------------------------------------------------------

    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

[[Page 28759]]

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.
---------------------------------------------------------------------------

    \242\ See supra Section III.C.1. for a discussion related to 
investment advisers' conflicts of interest.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \243\ The proposed rule requires funds to evaluate any pricing 
services that assist funds with the fair value determinations. See 
proposed rule 2a-5(a)(4). To the extent that the proposed rule's 
requirements related to pricing services differ from funds' current 
practices, the proposed rule could have second-order effects on 
pricing services' operations because pricing services could adjust 
their operations to cater to their clients' new demands. Because we 
believe that funds' current practices are generally similar to the 
proposed rule's requirements related to the evaluation of pricing 
services, we believe that the proposed rule would not have 
significant effects on pricing services.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \244\ The one-time cost estimates used in the economic analysis 
may differ from the cost estimates in Section IV below because (i) 
the cost estimates in the economic analysis capture all costs 
associated with the proposed rule while the cost estimates in 
Section IV capture only costs related to information collection 
burdens and (ii) the cost estimates in the economic analysis capture 
incremental costs associated with the proposed rule while the cost 
estimates in Section IV capture total costs. Hence, the cost 
estimates in Section IV below serve as an upper bound of costs 
related to information collection burdens for funds that do not have 
in place currently any practices that are similar to the proposed 
rule's requirements.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \245\ See supra footnote 215.
    \246\ 991.3 million = (485 UITs that would be affected by the 
proposed rule x $100,000 minimum one-time costs of the proposed rule 
x 85%) + (9,501 open-end funds, closed-end funds, variable annuity 
separate accounts, and BDCs that would be affected by the proposed 
rule x $100,000 minimum one-time costs of the proposed rule). 85% = 
70% of the one-time costs attributable to reviewing fair value 
practices and policies and procedures + 15% of the one-time costs 
attributable to reviewing recordkeeping practices. See supra 
footnote 215.
     5.9 billion = (485 UITs that would be affected by the proposed 
rule x $600,000 maximum one-time costs of the proposed rule x 85%) + 
(9,501 open-end funds, closed-end funds, variable annuity separate 
accounts, and BDCs that would be affected by the proposed rule x 
$600,000 maximum one-time costs of the proposed rule).
---------------------------------------------------------------------------

    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

[[Page 28760]]

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\
---------------------------------------------------------------------------

    \247\ See supra footnote 235.
---------------------------------------------------------------------------

    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.
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    \248\ We do not believe that the proposed rule would result in 
cost savings associated with boards' involvement in the 
determination of fair values because we believe that boards would 
reallocate time and attention to overseeing the adviser's fair value 
determinations or other activities unrelated to fair valuing fund 
investments.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \249\ See supra Section III.C.1. for a discussion related to 
investment advisers' conflicts of interest.
---------------------------------------------------------------------------

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.

[[Page 28761]]

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.
---------------------------------------------------------------------------

    \250\ We acknowledge that under the proposed rule, funds could 
face some uncertainty regarding how to comply with the proposed 
rule's requirements. Nevertheless, we believe that a more 
principles-based approach than the proposed rule would increase 
further any uncertainty regarding how to comply with the proposed 
rule's requirements.
---------------------------------------------------------------------------

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

[[Page 28762]]

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

[[Page 28763]]

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.
---------------------------------------------------------------------------

    \251\ 44 U.S.C. 3501-3520.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \252\ Proposed rule 2a-5(a) and (b).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \253\ See proposed rule 2a-5(e)(1) (defining ``fund'').
    \254\ See supra footnote 215 and accompanying text.
     The Commission's estimates of the relevant wage rates in the 
tables below are based on salary information for the securities 
industry compiled by the Securities Industry and Financial Markets 
Association's Office Salaries in the Securities Industry 2013. The 
estimated wage figures are modified by Commission staff to account 
for an 1,800-hour work-year and inflation, and multiplied by 5.35 to 
account for bonuses, firm size, employee benefits, overhead, and 
adjusted to account for the effects of inflation. See Securities 
Industry and Financial Markets Association, Report on Management & 
Professional Earnings in the Securities Industry 2013 (``SIFMA 
Report'').
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \255\ See supra Section II.E.2.
---------------------------------------------------------------------------

    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.

                                                Table 1--Fair Value Policies and Procedures PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                    Initial     Annual
                                       Internal initial       Internal annual                                          Internal    external    external
                                         burden hours         burden hours \1\                   Wage rate \2\        time costs     cost        cost
                                                                                                                                    burden      burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Establishing and implementing rule  6 hours..............  2 hours..............      x   $329 (senior manager).....     $658.00   $3,000.00   $1,000.00
 2a-5 policies and procedures.
                                    6 hours..............  2 hours..............      x   466 (ass't general              932.00  ..........  ..........
                                                                                           counsel).
                                    3 hours..............  1 hour...............      x   530 (chief compliance           530.00  ..........  ..........
                                                                                           officer).
                                    3 hours..............  1 hour...............      x   365 (compliance attorney).      365.00  ..........  ..........
Reviewing and updating rule 2a-5    .....................  3 hours..............      x   329 (senior manager)......      987.00  ..........    1,000.00
 policies and procedures.
                                    .....................  3 hour...............      x   466 (ass't general            1,398.00  ..........  ..........
                                                                                           counsel).
                                    .....................  1 hour...............      x   530 (chief compliance           530.00  ..........  ..........
                                                                                           officer).
                                   ---------------------------------------------------------------------------------------------------------------------

[[Page 28764]]

 
    Total annual burden per fund..  .....................  13 hours.............  ......  ..........................    5,400.00  ..........    2,000.00
Number of affected funds..........  .....................  9,986................  ......  ..........................       9,986  ..........       9,986
                                   ---------------------------------------------------------------------------------------------------------------------
    Total annual burden...........  .....................  129,818 hours........  ......  ..........................  53,924,400  ..........  19,972,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See SIFMA Report, supra footnote 254.

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\
---------------------------------------------------------------------------

    \256\ See proposed rule 2a-5(b)(1); supra section II.B.2 
(discussing the proposed board reporting requirements).
    \257\ See proposed rule 2a-5(b)(1)(i).
    \258\ See proposed rule 2a-5(b)(1)(ii).
    \259\ See proposed rule 2a-5(d).
    \260\ See supra footnote 215.
---------------------------------------------------------------------------

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

                                                         Table 2--Board Reporting PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                    Initial     Annual
                                       Internal initial       Internal annual                                          Internal    external    external
                                         burden hours           burden hours                    Wage rate \1\         time costs     cost        cost
                                                                                                                                    burden      burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   PROPOSED ESTIMATES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adviser written reports \2\.......  0 hours..............  8 hours..............      x   $329 (senior manager)....       $2,632      $2,000      $2,000
                                    0 hours..............  1 hour...............      x   17,860 (combined rate for       17,860  ..........  ..........
                                                                                           4 directors).
                                    0 hours..............  1 hour...............      x   365 (compliance attorney)          365  ..........  ..........
                                   ---------------------------------------------------------------------------------------------------------------------
    Total annual burden per fund..  .....................  10 hours.............  ......  .........................       20,857  ..........       2,000
Number of funds...................  .....................  x 9,501..............  ......  .........................      x 9,501  ..........     x 9,501
                                   ---------------------------------------------------------------------------------------------------------------------
    Total annual burden...........  .....................  95,010 hours.........  ......  .........................  198,162,357  ..........  19,002,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. See SIFMA Report, supra footnote 254.
2. See supra footnotes 245-247 and accompanying text.

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\
---------------------------------------------------------------------------

    \261\ See proposed rule 2a-5(a)(6); supra section II.A.6.
    \262\ See proposed rule 2a-5(b)(3); supra section II.B.6.
    \263\ While only 9,501 of these 9,986 funds would be subject to 
the last two of these recordkeeping requirements, we believe that 
this distinction is immaterial for this purpose and would result in 
only a de minimis lowering of the estimate. See also supra footnote 
215 and accompanying text.
---------------------------------------------------------------------------

    Table 3 below summarizes the proposed PRA initial and ongoing

[[Page 28765]]

burden estimates associated with the recordkeeping requirements under 
proposed rule 2a-5.

                                                          Table 3--Recordkeeping PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                    Initial     Annual
                                       Internal initial       Internal annual                                          Internal    external    external
                                         burden hours         burden hours \1\                   Wage rate \2\        time costs     cost        cost
                                                                                                                                    burden      burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   PROPOSED ESTIMATES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Establishing recordkeeping          1.5..................  .5...................  ......  $62 (general clerk).......         $31      $1,800      $1,800
 policies and procedures.
                                    1.5..................  .5...................  ......  95 (senior computer              47.50  ..........  ..........
                                                                                           operator).
Recordkeeping.....................  0 hours..............  2 hours..............      x   62 (general clerk)........          31           0           0
                                    0 hours..............  2 hours..............      x   95 (senior computer              47.50  ..........  ..........
                                                                                           operator).
                                   ---------------------------------------------------------------------------------------------------------------------
    Total annual burden per fund..  .....................  5 hours..............  ......  ..........................         157  ..........         600
Number of funds...................  .....................  x 9,986..............  ......  ..........................     x 9,986  ..........     x 9,986
                                   ---------------------------------------------------------------------------------------------------------------------
    Total annual burden...........  .....................  49,930 hours.........  ......  ..........................   1,567,802  ..........   5,991,600
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Establishing Recordkeeping Policies and Procedures,'' these estimates include initial burden estimates annualized over a three-year period.
2. See SIFMA Report, supra footnote 254.

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.

                                 Table 4--Proposed Rule 2a-5 Total PRA Estimates
----------------------------------------------------------------------------------------------------------------
                                                                             Internal burden     External  cost
                                                  Internal hour burden          time cost            burden
----------------------------------------------------------------------------------------------------------------
Policies and Procedures....................  129,818 hours................        $53,924,400        $19,972,000
Board reporting............................  95,010 hours.................        198,162,357         19,002,000
Recordkeeping requirements.................  49,930 hours.................          1,567,802          5,991,600
                                            --------------------------------------------------------------------
    Total annual burden....................  274,758......................        253,654,559         44,965,600
Number of funds............................  / 9,986......................            / 9,986            / 9,986
                                            --------------------------------------------------------------------
    Average annual burden per fund.........  27.51 hours..................             25,401              4,503
----------------------------------------------------------------------------------------------------------------

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

[[Page 28766]]

Analysis (``IRFA'') in accordance with section 3(a) of the Regulatory 
Flexibility Act (``RFA'').\264\ It relates to proposed rule 2a-5.
---------------------------------------------------------------------------

    \264\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \265\ See supra sections I, II.A, and II.C.
    \266\ See supra section II.B.
    \267\ See supra sections II.A.6 and II.B.4.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \268\ See supra section III and IV. These sections also discuss 
the professional skills that we believe compliance with the proposed 
rule would entail.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \269\ See rule 0-10(a) under the Investment Company Act [17 CFR 
270.0-10(a)].
    \270\ This estimate is derived an analysis of data obtained from 
Morningstar Direct as well as data reported to the Commission for 
the period ending December 2019.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \271\ Proposed rule 2a-5(a)(1)-(5).
    \272\ See proposed rule 2a-5(b)(2).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \273\ See supra section III.C.3. This section, along with 
section IV, also discusses the professional skills that we believe 
compliance with this aspect of the proposal would entail.
---------------------------------------------------------------------------

    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

[[Page 28767]]

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\
---------------------------------------------------------------------------

    \274\ See supra section III.C.1.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \275\ Proposed rule 2a-5(a)(6).
    \276\ Proposed rule 2a-5(b)(3).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \277\ See supra section III.C.3. This section and section IV 
also discuss the professional skills that we believe compliance with 
this aspect of the proposal would entail.
    \278\ See supra section III.C.1.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \279\ See supra section II.B.2 and II.B.3.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \280\ See supra section III.C.3.
    \281\ See supra section III.C.1.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \282\ See supra section II.A.5.
    \283\ Rule 38a-1(a)(2).
    \284\ See rule 38a-1(a)(4)(iii)(A). ``Material'' in this context 
is a change that a fund director would reasonably need to know in 
order to oversee fund compliance. See rule 38a-1(e)(2). We have also 
said that ``serious compliance issues'' must be raised with the 
board immediately. See Compliance Rules Adopting Release, supra 
footnote 26, at n.33.
---------------------------------------------------------------------------

    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

[[Page 28768]]

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\
---------------------------------------------------------------------------

    \285\ See supra section II.A.5.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \286\ See supra footnote 214 and accompanying text.
---------------------------------------------------------------------------

    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

[[Page 28769]]

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

0
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.
* * * * *
0
2. Section 210.6-03 is amended by revising paragraph (d) to read as 
follows:


Sec.  210.6-03   Special rules of general application to registered 
investment companies and business development companies.

* * * * *
    (d) Valuation of investments. The balance sheets of registered 
investment companies, other than issuers of face-amount certificates, 
and business development companies, shall reflect all investments at 
value, with the aggregate cost of each category of investment reported 
under Sec. Sec.  210.6-04.1, 6-04.2, 6-04.3, and 6-04.9 or the 
aggregate cost of each category of investment reported under Sec.  
210.6-05.1 shown parenthetically. State in a note the methods used in 
determining the value of investments. As required by section 28(b) of 
the Investment Company Act of 1940 (15 U.S.C. 80a-28(b)), qualified 
assets of face-amount certificate companies shall be valued in 
accordance with certain provisions of the Code of the District of 
Columbia.
* * * * *

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

0
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.
* * * * *
0
4. Section 270.2a-5 is added to read as follows:


Sec.  270.2a-5   Fair value determination and readily available market 
quotations.

    (a) Fair value determination. For purposes of section 2(a)(41) of 
the Act (15 U.S.C. 80a-2(a)(41)) and Sec.  270.2a-4, determining fair 
value in good faith with respect to a fund requires:
    (1) Assess and manage risks. Periodically assessing any material 
risks associated with the determination of the fair value of fund 
investments (``valuation risks''), including material conflicts of 
interest, and managing those identified valuation risks;
    (2) Establish and apply fair value methodologies. Performing each 
of the following, taking into account the fund's valuation risks:
    (i) Selecting and applying in a consistent manner an appropriate 
methodology or methodologies for determining (and calculating) the fair 
value of fund investments, including specifying:
    (A) The key inputs and assumptions specific to each asset class or 
portfolio holding; and
    (B) Which methodologies apply to new types of fund investments in 
which a fund intends to invest;
    (ii) Periodically reviewing the appropriateness and accuracy of the 
methodologies selected and making any necessary adjustments thereto;
    (iii) Monitoring for circumstances that may necessitate the use of 
fair value; and
    (iv) Establishing criteria for determining when market quotations 
are no longer reliable;
    (3) Test fair value methodologies. Testing the appropriateness and 
accuracy of the fair value methodologies that have been selected, 
including identifying the testing methods to be used and the minimum 
frequency with which such testing methods are used;
    (4) Evaluate pricing services. Overseeing pricing service 
providers, if used, including establishing:
    (i) The process for the approval, monitoring, and evaluation of 
each pricing service provider, and
    (ii) Criteria for initiating price challenges;
    (5) Fair value policies and procedures. Adopting and implementing 
written policies and procedures addressing the determination of the 
fair value of fund investments that are reasonably designed to achieve 
compliance with the requirements described in paragraphs (a)(1) through 
(4) of this section; and
    (6) Recordkeeping. Maintaining:
    (i) 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
    (ii) A copy of policies and procedures as required under paragraph 
(a)(5) of this section that are in effect, or were in effect at any 
time within the past five years, in an easily accessible place.
    (b) Performance of fair value determinations. The board of the fund 
must determine fair value in good faith for any or all fund investments 
by carrying out the functions required in paragraph (a) of this 
section. The board may choose 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 paragraphs 
(a)(1) through (5) of this section, subject to the requirements of this 
paragraph (b). If the board of the fund does not assign fair value 
determinations to an adviser to the fund, the fund must adopt and 
implement the policies and procedures required under paragraph (a)(5) 
of this section and maintain the records required by paragraph (a)(6) 
of this section.
    (1) Oversight and reporting. The board oversees the adviser, and 
the adviser reports to the fund's board, in writing, including such 
information as may be reasonably necessary for the board to evaluate 
the matters covered in the report, as follows:
    (i) Periodic reporting. At least quarterly, an assessment of the 
adequacy and effectiveness of the investment adviser's process for 
determining the fair value of the assigned portfolio of investments, 
including, at a minimum, a summary or description of:
    (A) The assessment and management of material valuation risks 
required

[[Page 28770]]

under paragraph (a)(1) of this section, including any material 
conflicts of interest of the investment adviser (and any other service 
provider);
    (B) Any material changes to, or material deviations from, the fair 
value methodologies established under paragraph (a)(2) of this section;
    (C) The results of the testing of fair value methodologies required 
under paragraph (a)(3) of this section;
    (D) The adequacy of resources allocated to the process for 
determining the fair value of assigned investments, including any 
material changes to the roles or functions of the persons responsible 
for determining fair value under paragraph (b)(2) of this section;
    (E) Any material changes to the adviser's process for selecting and 
overseeing pricing services, as well as material events related to the 
adviser's oversight of pricing services (such as changes in the service 
providers used or price overrides); and
    (F) Any other materials requested by the board related to the 
adviser's process for determining the fair value of assigned 
investments; and
    (ii) Prompt board reporting. The adviser reports 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, including a significant 
deficiency or material weakness in the design or implementation of the 
adviser's fair value determination process or material changes in the 
fund's valuation risks under paragraph (a)(1) of this section;
    (2) Specify responsibilities. The adviser specifies the titles of 
the persons responsible for determining the fair value of the assigned 
investments, including by specifying the particular functions for which 
they are responsible, and reasonably segregates the process of making 
fair value determinations from the portfolio management of the fund; 
and
    (3) Records when assigning. In addition to the records required in 
paragraph (a)(6) of this section, the fund maintains copies of:
    (i) The reports and other information provided to the board as 
required under paragraph (b)(1) of this section; and
    (ii) A specified list of the investments or investment types whose 
fair value determination has been assigned to the adviser pursuant to 
this paragraph (b), in each case 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.
    (c) Readily available market quotations. For purposes of section 
2(a)(41) of the Act (15 U.S.C. 80a-2(a)(41)), a market quotation is 
readily available 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.
    (d) Unit investment trusts. If the fund is a unit investment trust, 
the fund's trustee must carry out the requirements of paragraph (a) of 
this section.
    (e) Definitions. For purposes of this section:
    (1) Fund means a registered investment company or business 
development company.
    (2) Fair value means the value of a portfolio investment for which 
market quotations are not readily available under paragraph (c) of this 
section.
    (3) Board means 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.

    By the Commission.

    Dated: April 21, 2020.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2020-08854 Filed 5-12-20; 8:45 am]
 BILLING CODE 8011-01-P


