In a letter to SEC Investment Management Director Norm Champ, the Mutual Fund Directors Forum asked the Commission to issue principles-based guidance on fund valuation of securities recognizing the authority of fund directors to delegate valuation. The Fourm believes that principles-based guidance is the most effective and comprehensive way to address the wide variety of funds, boards, securities and investment instruments and product innovation and evolution in the dynamic mutual fund industry.
The statutory requirement that fund directors fair value securities in their portfolios that do not have readily available market values envisions an informed, engaged and independent board acting in good faith with respect to the valuation of portfolio securities, noted the forum, but it does not require that boards themselves directly value portfolio securities. Boards also have the flexibility to determine how involved they would like to be in the valuation process.
Because mutual funds must calculate their NAVs daily, most boards adopt policies and procedures to govern the method in which the NAV is to be determined on a day-to-day basis. Those procedures generally delegate to the adviser the determination of fair value for portfolio securities and other assets for which market quotations are not readily available. Delegation is appropriate both because the adviser generally has the required expertise to make judgments about fair value prices and has the resources available to make daily valuation determinations.
Fund directors do not abdicate their statutorily imposed responsibility to fair value securities by adopting policies and procedures that require the adviser to determine on a day to day basis the fair values of fund securities for which market quotations are not readily available. Rather, fund boards use the adviser to carry out the fair value function while fulfilling the board’s responsibilities to shareholders by reviewing and approving those procedures and then monitoring their implementation and ongoing effectiveness.
In the view of the Forum, boards, consistent with their business judgment, should have the flexibility to use experts (whether within the organization or outside) to provide the information necessary to perform their duties with respect to fair valuation. Just as in other areas, the board will approve the parameters of the relationship with the expert and establish a mechanism to review the expert’s performance.
The Forum urged that any guidance issued by the Commission should clarify that boards can adopt policies and procedures that require the adviser or other third party to assign values to a fund’s portfolio securities consistent with their Investment Company Act responsibility to fair value securities so long as the board provides effective oversight of the process. Boards should understand the policies and procedures regarding valuation of fund securities and the adviser’s day to day process in making necessary fair valuations. An understanding of the policies does not require, however, that fund directors be familiar with the intricacies of particular fair value pricing models.
Typically the adviser is the expert with the knowledge most relevant to assigning fair values to securities. Directors can be expected to understand the process that the adviser will use to value securities, particularly the identity of the parties making the determinations. Further, the board should understand how the adviser handles exceptions to the policies, including any overrides of prices received from third parties.
A board has many resources at its disposal to gain helpful insight into how well the fair valuation process is functioning, including the chief compliance officer and outside auditors. Boards should, however, be able to work with those parties in ways most appropriate for the particular facts and circumstances of the funds they oversee.
In developing guidance on valuation, the fund directors asked the Commission to focus on the principles that underlie and drive the valuation process, rather than on attempting to develop prescriptive approaches to valuing specific classes or types of securities. Doing so will permit the Commission to issue succinct guidance that is of real value to independent directors rather than a lengthy compendium of prior guidance and a list of potential approaches to various types of securities that would both be inflexible and be liable to become quickly outdated.
Given the rapid development of new types of securities, reasoned the Forum, guidance that focuses on how to value specific currently existing securities will not be helpful in the long run to funds or their investors. Moreover, the methods of valuing securities that exist today may change as well, as the manner in which those securities are traded and the liquidity of those securities may change rapidly over time.
Therefore, even relatively high-level guidance with respect to specific types of securities risks rapidly becoming outdated and potentially problematic. In contrast, principles-based guidance that focuses broadly on what funds should attempt to achieve when fair valuing portfolio securities is likely to lead to a better result, more accurate individual security valuations and, most importantly, more accurate daily NAVs.