Now’s the Time to Reflect on the Valuation Process – January 25, 2013
If you are involved with mutual fund boards of directors, you probably are aware of recent Securities and Exchange Commission (“SEC”) enforcement proceedings against boards and/or their investment advisers that allege incorrect valuing of portfolio securities or an apparent failure to oversee the process. While the latter is still open for interpretation and discussion, as the accused directors in the matter have vowed to fight the SEC charges, it still deserves attention, especially since it appears that a board must take an active role in the valuation process rather than relying too heavily on delegating day-to-day valuation decisions to the investment adviser and valuation committee.
But is reliance on delegating the valuation process the real issue? Does the SEC really expect the board to determine the daily value of portfolio securities, or should the real concern be that some boards might take such delegation to mean they can “bury their heads in the sand” and take no further responsibility for exercising appropriate oversight over the process? In accordance with SEC guidance, boards may delegate the day-to-day responsibility for the valuation process to others, starting with a subset of members: the valuation committee. However, implicit to delegation is oversight responsibility. It is on this that the board and valuation committee should reflect. The board needs to conduct periodic and regular due diligence of the valuation process to meet its legal obligation to fair value portfolio securities. The valuation committee, at the same time, needs to ensure that delegated parties carry out board-approved policies, which is crucial to satisfying the board’s oversight duty.
ACA has developed the following sample questions that boards and their valuation committees can use to help guide their review of fair-valuation policies, processes, and obligations. Additional questions will no doubt arise during the assessment process.
- Are the valuation committee’s scope of delegated authority and reporting obligations to the board clearly defined? Are the authority and obligations still relevant with respect to the types of funds overseen by the board?
- Has the board provided guidance to the valuation committee on how to fair value securities, including specific types of securities? Has the valuation committee communicated such guidance to fund management?
- Are reporting requirements being followed? Do the reports provide meaningful information to the board and valuation committee to allow them to (a) review the appropriateness of methods used to value securities, and (b) determine the basis for fair-value determinations or the reason certain methods were not used?
- How frequently does the valuation committee review and question individual fair values, fair-valuation methodologies, or fair-value issues raised by fund management? How does the committee document this action? Does fund management respond in a documented and timely manner?
- What is the escalation policy for fund management to bring fair-value situations to the valuation committee’s attention? What reporting is provided in support of established methodologies? Does the valuation committee receive fair-valuation memorandums at the time of a fair-value determination or at the next quarterly meeting? Do committee meeting minutes reflect all discussions of valuation? Do committee materials contain memorandums discussing valuation? Does the board ratify the fair-valuation determinations?
- Does the board or the valuation committee periodically request reports from fund management that discuss the full valuation process? What issues have been identified? How are they resolved?
- Are approved pricing vendors and their quality of prices regularly reviewed? Are primary vendor prices regularly compared against secondary vendor prices? Are price tolerances established that result in further price evaluation if breached?
- When employing a third party to value non-U.S. securities, are reports being requested that compare the fair values versus the next-day open price? Have the established “event trigger” and vendor been reviewed since initial implementation?
- Are prices on newly established positions or new offerings compared against the cost of the positions to ensure reasonableness of the vendor price?
- Are fair values compared against observed sale prices or against vendor prices or broker prices once deemed reliable again?
- What ongoing monitoring of market and other events does the valuation committee use to determine the continued validity of prices? When presented with issues similar to the 2008/2009 credit crisis, does the valuation committee reevaluate procedures for determining prices for securities that have been deemed illiquid or have experienced deteriorating credit quality?
- Does the valuation committee receive reports on stale prices, price challenges made by investment managers, or items that resulted in price overrides of vendor prices?
- Are identified NAV errors that do not meet the 1/2 of 1% threshold being escalated to the valuation committee?
We encourage boards and valuation committees to thoroughly, deliberately, and objectively review and discuss their fair-valuation policies, processes, and obligations. While the answers to some of the questions above may seem obvious and some questions may seem to take you backwards, we still encourage you to ask them. The answers to these and other questions will help ensure the fair-valuation process is “owned” by the board rather than simply delegated.
ACA Compliance Group assists mutual funds and their sponsors in reviewing their adopted valuation policies and procedures and can perform independent regulatory assessments of the valuation and board-reporting process.
For more information on our consulting services described above or to learn more about our Investment Company Services Division, please email