Caveat Emptor Redux: SEC guidance for US Mutual Funds on the use of pricing services.

Peter Jones Nov 03, 2015

The SEC chose an 800+ page release in 2014 ostensibly focused on other matters, titled – “Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166, July 23, 2014” to provide some additional guidance on pricing for US Mutual Funds, notably on the use of pricing services.

Ian Blance

Managing Director, Voltaire Advisors LLP

"Regardless of whether it appoints the adviser or a valuation committee to perform the fair value task, it is incumbent on a fund’s board to both understand and oversee the process."
Ian Blance

About Our Independent Advisory

The content of this guidance came as a surprise, not to say a shock, to some mutual fund boards and their directors constituted under the Investment Company Act of 1940.

Whilst recognising that the use of pricing services by mutual funds is both a widespread and acceptable method of helping funds to ‘fair value in good faith’ assets where ‘market prices are not readily available’ the SEC reiterated much of its guidance from ASR 118 (1970) and 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. We note that a fund’s board of directors has a non-delegable responsibility to determine whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund’s portfolio security.”
SEC Investment Company Act Release No. 31166 Section III, D, 2
“it is incumbent upon the [fund’s] Board of Directors to satisfy themselves that all appropriate factors relevant to the value of securities for which market quotations are not readily available have been considered,” and that fund directors “must . . . continuously review the appropriateness of the method used in valuing each issue of security in the [fund’s] portfolio.”
ibid
So much we all knew, or should have known!.

It was the subsequent comments on the duties of the board of directors in relation to pricing services that really put a cat amongst the pigeons!

“Before deciding to use evaluated prices from a pricing service to assist it in determining the fair values of a fund’s portfolio securities, the fund’s board of directors may want to consider the inputs, methods, models, and assumptions used by the pricing service to determine its evaluated prices, and how those inputs, methods, models, and assumptions are affected (if at all) as market conditions change.”
ibid

And

“In choosing a particular pricing service, a fund’s board may want to assess, among other things, the quality of the evaluated prices provided by the service and the extent to which the service determines its evaluated prices as close as possible to the time as of which the fund calculates its net asset value. the fund’s board should generally consider the appropriateness of using evaluated prices provided by pricing services as the fair values of the fund’s portfolio securities where, for example, the fund’s board of directors does not have a good faith basis for believing that the pricing service’s pricing methodologies produce evaluated prices that reflect what the fund could reasonably expect to obtain for the securities in a current sale under current market conditions.”
ibid

One immediate interpretation of this which caused a frisson of panic was that the fund’s board themselves needed to be experts in fair valuation techniques rather than relying on their appointees in the investment adviser, valuation committee or independent experts such as ourselves. Given the typical make up of mutual fund boards this seemed a pretty tall order!

A few weeks ago we chaired a session at V-FI Americas in New York on mutual fund valuation issues which consisted of an update from the SEC on this issue, followed by a distinguished panel of fund pricing professionals commenting on their experiences. This event shed some new light on the guidance that is worth relating.

The first thing to note was that the SEC did not feel that the 2014 guidance said anything new. Boards have always had a non-delegable responsibility for fair value, and whilst they are able to appoint others to help them with this duty, they must ultimately satisfy themselves that it is being done properly and fairly. Furthermore, this must not be a ‘set and forget’ exercise - the board must regularly review these policies and procedures to ensure that they remain appropriate.

On being questioned about the detailed knowledge apparently required on ‘inputs, methods, models and assumptions’, the Commission did not believe that this implied that fund board directors needed to become experts on evaluated pricing techniques. However, they did state that, given the nature of their fiduciary duties, having in place some means of periodically overseeing these underlying components of the asset valuation function was a required feature of board responsibility.

The panel discussion that followed looked at a number of the challenges associated with this oversight.

Best practice when it came to due diligence on pricing services was outlined, as were the changes that practitioners had seen since the new guidance – including some fund board members attending vendor due diligence meetings! The panel did not feel that this was necessarily helpful, but they were unanimous in their expectation that the board should take full note of all the work done in this respect.

One highly plausible suggestion from the panel – one that we share - was that the Commission was prompted to reiterate the fund board’s duties with regard to pricing by the perceived failings of directors in the Morgan Keegan case. This enforcement occurred in 2011 for the adviser and some of its staff, but in 2013 the fund directors were also sanctioned (In the Matter of J. Kenneth Alderman et al., Investment Company Act Release No. 30557 (June 13, 2013) (settlement)).

As the Administrative Proceeding stated …

“The Directors did not specify a fair valuation methodology pursuant to which the securities were to be fair valued. Nor did they continuously review how each issue of security in the Funds’ portfolios were being valued. The Directors delegated their responsibility to determine fair value to the Valuation Committee of the investment adviser to the Funds, but did not provide any meaningful substantive guidance on how those determinations should be made. In addition, they did not learn how fair values were actually being determined. They received only limited information on the factors considered in making fair value determinations and almost no information explaining why fair values were assigned to specific portfolio securities. These failures were particularly significant given that fair valued securities made up the majority—and in most cases upwards of 60%—of the Funds’ net asset values (“NAVs”) during the Relevant Period.”
SEC Investment Companies Act Release No. 30557
The conclusions which can be drawn from all this seem quite clear.

Regardless of whether it appoints the adviser or a valuation committee to perform the fair value task, it is incumbent on a fund’s board to both understand and oversee the process. In the event that a pricing service is used to assist in this task, this applies equally to them and a board should appraise themselves of the pricing service methodology and processes and satisfy themselves that these are appropriate. They are also required to keep this under ‘continuous review’. ‘Set and Forget’ is not an option - ignore at your peril …