Regulatory and Accounting Standards on the Valuation of Portfolio Securities
By John N. Ake and Martha J. Hays

The valuation of portfolio securities remains an important issue for investment companies and their boards of directors. The inspection staff in the Division of Investment Management at the Securities and Exchange Commission (SEC) has been reviewing in greater depth policies and procedures that fund boards have adopted to value portfolio securities. As a result of the SEC’s market timing investigations, the SEC has required funds provide more disclosure regarding valuation policies and procedures. Moreover, over the last several years, the SEC has instituted enforcement actions against funds and their boards, including fund independent directors, in situations where portfolio securities were not properly valued.

Since 1969, the SEC has issued five major interpretations on the valuation standards required by the Investment Company Act of 1940, as amended (the 1940 Act). The issuance by the Financial Accounting Standards Board (FASB) in September 2006 of Statement of Financial Accounting Standards No. 157 (FAS 157) on Fair Value Measurements will require investment companies to factor into their valuation processes the measurement principles set forth in FAS157, as well as prior SEC guidance on fair value. FAS 157 is applicable to financial statements for fiscal years ending after November 15, 2007, as well as any interim periods within such fiscal years.

This article provides an overview of the statutory framework for valuation of portfolio securities, then discusses FAS 157 and SEC pronouncements on valuing securities. Following those discussions, the article discusses compliance obligations, director obligations and litigation and disclosure obligations regarding valuation of securities.

Statutory Requirements

Current Net Asset Value — The Investment Company Act of 1940, as amended (the 1940 Act), requires open-end investment companies to sell and redeem their shares at a price based on “current net asset value.” Section 2(a)(32) of and Rule 2a-4 under the 1940 Act define “current net asset value” as the amount that reflects calculations made substantially in accordance with the following guidelines:

• Portfolio securities for which market quotations are readily available must be valued at current market value;
• Other securities and assets for which market quotations are not readily available must be valued at fair value as determined in good faith by the company’s board of directors;
• Changes in portfolio holdings must be reflected no later than the first business day following the trade date.

The 1940 Act does not define “readily available market quotation,” “fair value,” or the term “good faith” in the context of the valuation of portfolio securities and assets.

Readily Available Market Quotation — What is meant by “readily available market quotation?” The answer varies. An exchange-traded security would generally have a readily available market quotation. Securities regularly traded by dealers in the 144A institutional market are also generally considered to have readily available market quotations. Other securities that are not listed on an exchange, but are regularly traded by dealers, are considered to have readily available market quotations. At what point do thinly traded securities not have a regularly available market quotation? In addition, are there certain events that can cause a security to have a price that is not considered a readily available market quotation?

The Staff of the Division of Investment Management at the SEC (the Staff) has indicated that a security may no longer have a readily available current market quotation under certain circumstances, including:

• When the market for the security closes before the fund values its securities (typically 4:00 p.m. Eastern time, when the major U.S. exchanges close);
• When a security is subject to a trading halt and the halt remains in effect at the end of the day;
• When entire markets close, as a result of a significant event (weather, terrorism, natural disasters or massive electrical outages);
• When markets close due to scheduled holidays;
• When there is no trading in a security; or
• When another “significant event” occurs, either with respect to an individual issuer, or with respect to a sector, the economy or a country as a whole.

Once a determination has been made that market quotations are not readily available for a security, that security must be valued, in good faith, at its fair value.

Fair Value Determinations

The SEC first issued guidance on fair valuation determinations in the context of restricted securities in 1969 in ccounting Series Release No. 113 (ASR 113) (October 21, 1969). That release was followed by Accounting Series Release No. 118 (ASR 118) (December 23, 1970), in which the SEC sought to provide more general valuation guidelines. In 1999, the staff of the Division of Investment Management (the Staff) issued an interpretative letter to the Investment Company Institute (the 1999 Letter) (December 8, 1999) in an effort to clarify and provide additional guidance on pricing issues in the case of an emergency or other unusual situations, and issued follow-up advice in 2001 with regard to the valuation of foreign securities in the form of a second interpretative letter to the Investment Company Institute (the 2001 Letter) (April 30, 2001). More recently, the Staff provided “best practices” guidance in a speech by Lori Richards, Director of the Office of Compliance, Inspections and Examinations (the Richards Speech) (June 14, 2002). Each of these interpretations expanded the factors that investment company boards of directors must take into account when making fair value determinations.¹

As a result of FASB’s adoption of FAS 157, investment company boards now also need to take into account FASB’s
framework for measuring fair value in generally accepted accounting principles. FASB adopted FAS 157 to provide
issuers with more consistent definitions of fair value and better guidance for making fair value measurements.

Statement of Financial Accounting Standards No. 157 (September 2006)

Fair Value — FAS 157 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.”² This definition requires an investment company to use fair value measurements to determine the exit price for a security, and not the price that would be paid to acquire the asset (an entry price).

Fair value is a market-based measurement, not an entity specific measurement, so that the fair value price is what the
owner would receive upon the sale of the asset, and is not the intrinsic value of the asset.

Under FAS 157, a fair value measurement assumes the exchange of an asset in an orderly transaction between market
participants to sell the asset on the measurement date.

An orderly transaction is one that:

• assumes exposure to the market for a period prior to the measurement date to allow for the marketing activities that are usual and customary for transactions involving such assets; and
• is not a forced transaction (for example, not a forced liquidation or distressed sale).

The transaction is hypothetical, and considered from the perspective of the participant that holds the asset.

Market participants are:

• buyers and sellers in the principal (or most advantageous) market;
• independent of the investment company (not related parties);
• knowledgeable regarding the asset and the transaction;
• able to transact for the assets; and
• willing to transact; motivated, but not forced to or otherwise compelled to engage in the transaction.

The investment company determines fair value based on the assumptions that the market participants would use in pricing the asset. The investment company need not identify specific market participants. Rather, it should identify the
characteristics that distinguish market participants.

A fair value measurement also assumes that the transaction occurs in the principal market for the asset, or in the absence of a principal market, the most advantageous market for the asset.

The principal market is the market in which the investment company would sell the asset with the greatest volume and level of activity for such asset.

The most advantageous market is the market in which the reporting entity would sell the asset with the price that maximizes the amount that would be received.

Again, the principal, or most advantageous market, is considered from the perspective of the hypothetical seller of the asset. The price is not adjusted for transaction costs, which FAS 157 defines as the incremental direct costs to sell the asset in the principal (or most advantageous) market.

Under FAS 157, a fair valuation measurement assumes the highest and best use of the asset by market participants. For
investment companies, the highest and best use of the assets is “in-exchange,” since the asset would provide maximum value to market participants principally on a stand-alone basis.

Valuation Techniques and Inputs — Under FAS 157, companies should use one or more of the following valuation
techniques in making fair valuations: market approach, income approach, and/or cost approach. Investment companies
typically use a market approach due to the nature of their assets. The market approach uses the price and other relevant information generated by market transactions involving identical or comparable assets.

FAS 157 discusses the use of “inputs,” which refers to the assumptions market participants would use in pricing the asset or liability. Inputs can be either observable (inputs developed based on market data obtained from sources independent of the investment company) or unobservable (inputs developed by the investment company that reflect its own assumptions regarding the assumptions other market participants would use in pricing the asset).

A fair value hierarchy for inputs into fair value measurement techniques is set forth in FAS 157. The highest priority is given to quoted prices (unadjusted) in active markets for identical assets (Level 1 inputs), and the lowest priority is given to unobservable inputs (Level 3 inputs). The level that is used is the lowest level in which the fair value measurement in its entirety falls when an input is significant.

Level 1 inputs — According to FAS 157, a quoted price in an active market³ provides the most reliable evidence of fair value and shall be used to measure fair value whenever available unless:

• The reporting entity holds a large number of similar assets (for example, debt securities) that are required to be measured at fair value and a quoted price in an active market might be available, but not readily accessible for each of the assets individually. In that case, fair value may be measured using an alternative pricing method that does not rely exclusively on quoted prices (for example, matrix pricing).
• There has been a significant event after the close of the market. In this circumstance, closing quoted prices may not accurately reflect fair value at the measurement date.

In the case of Level 1 inputs, the quoted price shall not be adjusted because of the size of the position held relative to the trading volume (the Blockage Factor).

Level 2 inputs — The next highest priority to Level 1 inputs are Level 2 inputs, which are observable inputs other than
quoted prices. Examples of Level 2 inputs are:

• Quoted prices for similar assets in active markets.
• Quoted prices for identical or similar assets in non-active markets.
• Inputs other than quoted prices that are observable (for example, interest rates and yield curves).
• Inputs that are derived principally from or corroborated by observable market data by correlations or other means.

Level 2 inputs include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices of specific securities, but rather on the securities’ relationship to other benchmark quoted securities. Level 2 inputs would also include pricing evaluations provided by independent pricing services.

Level 3 inputs — The lowest priority level in the hierarchy is Level 3 inputs. These inputs are unobservable inputs based primarily upon the investment company’s assumptions about the assumptions that market participants would use in pricing the asset (including assumptions about risk). Unobservable inputs are developed based on the best information available in the circumstances, which might include the investment company’s own data. It is not necessary for an investment company to undertake all possible efforts to obtain information for Level 3 inputs, but the company cannot ignore information about market participants that is reasonably available without undo cost or effort. Again, the investment company is looking for an exit price.

Bid-ask spread — If the input used to measure fair value is based on bid and ask prices, the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value, regardless of where in the fair value hierarchy the input falls. FAS 157 does not preclude the use of mid-market pricing within a bid-ask spread.

Valuation techniques used to measure fair value are to be consistently applied. However, a change in a valuation
technique is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances.

SEC Pronouncements

In contrast to FAS 157, which applies to all public companies, the SEC has provided specific guidance to investment
companies regarding the factors funds should consider in making fair valuations.

Accounting Series Release No. 113 (Restricted Securities) (October 21, 1969) — ASR 113 defines fair value to be “the amount which the owner might reasonably expect to receive for [the securities] upon their current sale.” Although there can be no “automatic formula” by which an investment company can value restricted securities, ASR 113 requires that a fund’s board of directors consider all relevant factors, including the operations of the issuer, changes in general market conditions and the extent to which the inherent value of the securities may have changed.⁴

To illustrate the concept of fair value pricing and the necessity that a fund board consider all relevant factors, ASR 113 rejects four methods of valuation:

• The continued valuation of restricted securities at cost where changes in the issuer’s operations or general market
  conditions indicated that cost no longer represents fair value.
• The application of either a constant percentage or an absolute dollar discount to the market price for unrestricted
  securities of the same class without regard to other relevant factors such as the extent to which the inherent value of the securities may have changed.
• The valuation of restricted securities by reference to the market price for unrestricted securities (this method improperly assumes that the market price for unrestricted securities of the same class is representative of the fair value of the restricted securities).
• The valuation of restricted securities, acquired at prices below market quotations for similar unrestricted securities, by amortizing the difference over a period of time on the assumption that the unrestricted securities will be sold at the market price at the expiration of such time period.

Accounting Series Release No. 118 (General Guidance) (December 23, 1970) — The SEC provided significant additional guidance in ASR 118 with respect to the process by which a fund values its portfolio securities. The SEC noted that where market quotations are not readily available, either as a result of the lack thereof or a fund’s determination that the existing quotations are unreliable or otherwise invalid, a fund must price its securities at fair value. In fair value pricing:

It is incumbent upon the 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 to determine the method of arriving at the fair value of each such security . . . The board must also, consistent with this responsibility, continuously review the appropriateness of the method used in valuing each issue of security in the company’s portfolio.

ASR 118 delineates several non-exclusive methods of valuation a board may use when acting in good faith to value
portfolio securities. These valuation methods may be based on:

• a multiple of earnings;
• a discount from the market price of a similar freely traded security;
• a yield to maturity with respect to debt issues; or
• a combination of these principles.

Further, a fund’s board of directors should consider several general factors when choosing a valuation method, including: (1) the fundamental and analytical data relating to the investment; (2) the nature and duration of any restrictions on disposition of the securities; and (3) an evaluation of the forces that influence the market in which the securities are purchased and sold.

Finally, ASR 118 specifies a number of more specific factors a board should consider, including: (1) the type of security; (2) the financial statements of the issuer; (3) the cost of the security at the date of purchase; (4) the size of the fund’s holdings; (5) the discount from market value of unrestricted securities of the same class at the time of purchase; (6) special reports prepared by analysts; (7) information as to any transactions or offers with respect to the security; (8) the existence of merger proposals or tender offers affecting the securities; (9) the price and extent of public trading in similar securities of the issuer or comparable companies; and (10) any other relevant matters.

Taken together, these valuation methods, and the general and specific factors, provide a framework within which fund directors must work to price at fair value securities for which market quotations are not readily available. However, ASR 118 makes clear that such factors are not exclusive. Rather, in order to comply with its duty of good faith, a fund’s board of directors must take into account all available indicators of value in an effort to determine the amount that the board
might reasonably expect to receive upon the current sale of each security.

Investment Company Institute No-Action Letter (December 8, 1999) (Emergency or Unusual Situations) — The Staff of the SEC issued the 1999 Letter to provide guidance with regard to the valuation of fund shares during emergency or unusualsituations. The 1999 Letter clarified that market quotations for portfolio securities are not “readily available” when the exchange or market on which the securities trade is not open for trading for an entire day, and that funds, accordingly, must price those securities based on their fair value.

The 1999 Letter also expanded on ASR 118’s list of general and specific factors a board should consider when fair value pricing portfolio securities. For example, the Staff noted that the available fundamental, analytical information with respect to a security is generally the most important factor a fund’s board should consider. Several external sources of information that should also be considered include: (1) the value of other financial instruments, including derivative securities traded on other markets or among dealers; (2) the trading volumes on markets, exchanges or among dealers; (3) the value of baskets of securities traded on other markets, exchanges or among dealers; (4) changes in interest rates; (5) observations from financial institutions; (6) government (foreign or domestic) actions or pronouncements; and (7) other news events.

The 1999 Letter sought to provide fund boards some guidance regarding what constitutes good faith in the context of fair value pricing. To that end, the 1999 Letter acknowledges that good faith is “a flexible concept that can accommodate many different considerations, including the incorporation of a variety of sources of information.” Indeed, the action a mutual fund board must take to satisfy its duty of good faith varies, depending upon the type of the fund, the circumstances under which the board is undertaking to price at fair value a security, and any pricing procedures the board has adopted.

The 1999 Letter acknowledged with approval that in light of the changes in the securities markets, fund boards are generally only indirectly involved in the day-to-day pricing of a fund’s portfolio securities. As such, the Staff recognizes that most boards satisfy their pricing obligations by reviewing and approving pricing procedures and methodologies proposed by fund management. When reviewing such pricing procedures, a board’s good faith obligation requires the board to determine whether the proposed methodologies and procedures are reasonably likely to result in the valuation of portfolio securities at prices the fund could expect to receive upon their current sale.

Investment Company Institute No-Action Letter (April 30, 2001) (Foreign Markets) — The Staff of the SEC issued the 2001 Letter to provide additional guidance on several other issues that arise in the valuation of portfolio securities,
particularly foreign securities.

The 2001 Letter also reiterates the Staff’s view that a fund’s board must continuously review the appropriateness of the
policies and procedures the fund uses in valuing portfolio securities. Such reviews should be intended to evaluate whether those policies and procedures “continue to result in values that [the board] might reasonably expect to receive upon a current sale.” Funds should assess the availability and reliability of market quotations, and should regularly test the accuracy of their fair value prices by comparing them with values that are available from other sources, including actual trade prices, as well as quotations from pricing services and dealers. In using pricing services, funds should recognize that these services provide an indication of prices, and therefore they should be used for “evaluating” fair market value, not “valuation.”

Moreover, in the Staff’s view, a fund’s board:

acts in good faith when its fair value determination is the result of the sincere and honest assessment of the amount that the fund might reasonably expect to receive for security upon its current sale, based upon all of the appropriate factors that are available to the fund. Furthermore, . . . a Board acts in good faith when it continuously reviews the appropriateness of the method used in determining the fair value of the Fund’s portfolio securities.

By contrast, where a fund board knows or has reason to believe that its fair value determination does not reflect the amount the fund might reasonably expect to receive for the security upon its current sale, or a board acts with reckless disregard for whether its fair value determination is appropriate, a fund board would not be deemed to have acted in good faith.

Richards Speech (Best Practices) (June 14, 2002) — In a speech given in 2002, Ms. Richards, Director, Office of Compliance, Inspections and Examinations, discussed the results of recent SEC inspections of fund pricing procedures and provided a list of recommendations that reflect the Staff’s view of valuation “best practices:”

• Guard against a lack of oversight of valuation—make sure that there are good checks and balances in the valuation process.
• Because there is a degree of expertise needed to handle valuation and pricing issues, some fund boards have established valuation committees to focus specifically on valuation issues when they arise. The adviser may also have a valuation committee, and many funds have a director on call. These committees should have written policies, hold regular meetings, and keep minutes.
• The more difficult a security is to value, the more the board should be involved in understanding the pricing methodology. The board needs to understand the pricing process—and will want to review the process with the adviser—including the criteria considered and the valuation methods used.
• If you use a pricing service, understand exactly what services that pricing service provides. Pricing services vary: they may give you NASDAQ quotes; they may give you their best estimate of value based on communications with the underwriter or issuer; or they may spit back at you exactly the information that your portfolio manager has provided to them.
• Some funds use more than one pricing service—this allows the fund to obtain two independent pricing recommendations, and can provide a check for discrepancies. The portfolio manager can be used as a reviewer of valuations of individual securities (he or she will have good knowledge of the market in that security, and could do an “end-of-the-day check”). But, do not rely solely on the portfolio manager for valuations; he or she has a built-in conflict of interest.
• Many advisers have an automated checking routine that searches for day-to-day price changes in individual securities over some threshold percentage and that kicks these out for review. Be sure that someone actually checks on the reasons for the increase or the decrease in the prices.
• Sometimes prices that come in from external sources (e.g., a pricing service or broker-dealer) are overridden by the adviser. Have controls on pricing overrides. Make sure that there are policies outlining when overrides are allowed and that there are procedures to ensure supervisors’ approval and documentation of all overrides.
• Ensure that someone who is not involved in the pricing process, such as compliance staff, reviews all overrides to look for individual overrides that are not supportable, and patterns of overrides that suggest problems. Also consider providing a periodic report to the board on all overrides and the reasons for them.
• Monitor for “stale pricing” (when the price of a security does not change). Is someone overriding incorrectly or is something wrong with the input?

Ms. Richards noted that if funds are using fair value, they should compare any sales in the market to the fair value for
accuracy. Also, funds should review any differences that occur over time for any bias that suggests that the fair values being used are either consistently higher or lower than actual sales prices. Also, management should consider providing this data to the board (e.g., quarterly) so that it can ensure it is overseeing the process.

Compliance Matters

In 2003, the SEC adopted a new compliance rule (Investment Company Act Rule 38a-1 (ICA Rel. No. 26299; December 17, 2003) that requires investment companies to adopt, and boards of directors to approve, written compliance policies and procedures, including procedures covering the pricing of portfolio securities. The SEC in its adopting release noted that with respect to the pricing of portfolio securities, funds must have written procedures to monitor for events that may necessitate fair value pricing, and must pay attention to circumstances that would suggest the need for using fair value pricing. The policies and procedures should also:

• establish criteria for determining when market quotations are no longer reliable for a particular portfolio security;
• provide a methodology or methodologies by which the fund determines the current fair value of the portfolio
  security;
• regularly review the appropriateness and accuracy of the method used in valuing securities, and make any necessary adjustments; and
• require fair valuation of portfolio securities whenever market quotations become unreliable.

The SEC noted that the failure of a fund to establish sufficiently sensitive criteria for using fair value pricing should be recognizable in subsequent reviews of the accuracy of the prices used to compute the net asset value of the fund. In the adopting release, the SEC noted that in determining fair value for foreign securities, some funds use correlations between the exchange prices of foreign securities and other appropriate instruments or indicators, such as relevant indices, American Depository Receipts, and futures contracts.

Role of Directors and Litigation

Notwithstanding the SEC’s interpretations described above, it is well recognized that fund boards are not typically in a position to be involved in day-to-day deliberations that take place in connection with valuation determinations. In ASR 118, the Staff appropriately provided for a fund’s board of directors to “appoint persons to assist them in the determination of value and to make the actual calculations.” Board designees can thus assist in the formulation of those policies, procedures and methodologies used in fair value determinations. However, the board’s good faith obligation extends to approval of the policies, procedures and methodologies its designees formulate, periodic review of the overall valuation procedures and consideration of any appropriate modifications. Moreover, recent litigation highlights the danger to directors of failing to fulfill their obligations in the valuation process.

In re Parnassus Investments (Adm. Proc. Initial Decisions Rel. No. 131; September 3, 1998)

In 1998, the SEC instituted administrative proceeding against the investment adviser, executive officers and independent directors of the Parnassus Fund for mispricing a portfolio security from an issuer (Margaux) that had filed for bankruptcy protection. The adviser and the Board of Directors had priced the security (a convertible bond) after bankruptcy under different and various protocols over an extended period of time. These protocols included conversion
valuation, conversion valuation with a premium, going concern valuation, and “orderly disposition” valuation. The Administrative Law Judge found that the Board’s valuation methods did not meet the standards required under ASR 113 and 118, and that the determinations made by the Board of the fair value of the Margaux convertible bond were not made in good faith.

In the Matter of Western Asset Management Co. and Legg Mason Fund Advisor, Inc., Respondents (IAA Rel. No.1980; September 28, 2001)

On September 28, 2001, the SEC entered into an offer of settlement with Western Asset Management Co. (Western)
whereby Western agreed to pay $50,000 for failing to adequately supervise one of its portfolio managers when pricing securities that were not publicly traded. The offering documents of one of the funds provided that in the absence of readily available market quotations, prices would be obtained from recognized broker-dealers in the same or similar securities. The offering documents of another of the funds provided that securities with no readily available market
quotes would be valued at fair value under the supervision of the fund’s managing director and supervisory board. In
valuing fund securities without readily available market quotes, the portfolio manager instead relied on the investment
banking firm from whom the securities were purchased to supply a valuation. The SEC found that Western failed to
have adequate policies and procedures in place to ensure the funds in question were priced in compliance with the fund’s offering documents.

In re Hammes (ICA Rel. No. 26290; December 11, 2003)

On December 11, 2003, the SEC brought a series of separate enforcement actions against the investment adviser, executive officers, portfolio pricing agent and the independent directors of the Heartland Funds arising out of a significant mispricing of certain municipal bond securities in the Funds’ portfolios. The SEC issued a cease and desist order against the independent directors noting that they had committed violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act because they did not adequately discharge their responsibility to participate meaningfully in the valuation of Funds. The SEC stated that:

While mutual fund directors are permitted to delegate some responsibility for pricing a fund’s securities to a separate committee, each director retains responsibility to be involved in the valuation process and may not passively rely on securities valuations provided by such a committee….

Furthermore, a director’s failure to review financial statements, reports, contracts, and other documents relevant to the financial condition of the issuers of a fund’s securities can result in the director’s personal liability….

Here, the [directors] failed to take adequate steps to follow up on their requests for information from Heartland Advisors, when they were on notice of the problems with the prices of the Funds’ securities, in order to assure that the Funds’ securities were priced at fair value.

Disclosure Obligations
FAS 157

FAS 157 requires funds to disclose in their annual and semi-annual financial statements information that enables users of their financial statement to assess the inputs used to develop fair value measurements, and for recurring fair value measurements using Level 3 inputs, the effect of the measurements on earnings or changes in net assets for the period. A fund must disclose separately for each major category of assets and liabilities:

• The fair value measurements at the reporting date;
• The Level (1, 2 or 3) within the fair value hierarchy in which the fair value measurements in their entirety fall;
• For fair value measurement using significant Level 3 inputs, a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to: (i) total gains and losses for the period; (ii) purchases, sales, issuances and settlements (net); and (iii) transfers in and/or out of Level 3;
• The amount of total gains or losses for the period described in the foregoing bullet included in earnings that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealized gains or losses are reported in the statement of income (or activities);
• In annual periods only, the valuation techniques that are used to measure fair value and a discussion of changes
  in valuation techniques, if any, during the period.

Additional disclosure is also required if a fund values assets at fair value on a non-recurring basis (such as an impaired
asset).

Appendix A to FAS 157 provides a tabular format to beused to provide the quantitative disclosures required by FAS
157.

Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings (ICA Rel. No. 26418; April 16, 2004)

In 2004, the SEC began requiring funds (other than money market funds) to provide a brief explanation of the circumstances under which they will use fair value pricing and the effects of using fair value pricing. In adopting this rule, the SEC noted fair value pricing protocols would differ based upon the characteristics of the portfolio securities. For example, the SEC indicated:

if a fund invests exclusively in frequently traded exchange listed securities of large capitalization domestic issuers and calculates its NAV as of the time the exchange typically closes, there may be very limited circumstances in which it would use fair value pricing (e.g., if the exchange on which a portfolio security is principally traded closes early or if trading in a particular portfolio security was halted during the day and did not resume prior to the fund’s NAV calculation). By contrast, if a fund invests primarily in securities that are traded on overseas markets, we would expect a fuller discussion of the circumstances under which the fund would use fair value pricing, such as specific events occurring after the close of the overseas exchange that would cause the fund to use fair value pricing.

The SEC clarified that this new disclosure rule does not “require disclosure of the specific methodologies and formulas that a fund uses to determine fair value prices. For example, if a fund has a policy to fair value price securities traded on overseas markets in the event that there is a specific percentage change in the value of one or more domestic securities indices following the close of the overseas markets, the fund will not be required to disclose the specific percentage change that would trigger fair valuation. In addition, a fund’s disclosure need not be so specific that the fund may not adjust the triggering events from time to time in response to market events or other changes.”

Conclusion

In light of FAS 157, funds should reassess their valuation policies and financial statement disclosure procedures to ensure that such policies and procedures are consistent with both FAS 157 and prior SEC pronouncements. Directors of funds should assure themselves that this assessment has been conducted, and that all policies and procedures have been revised and implemented in a timely manner.

Notes

1. This outline does not address valuation of securities in money market funds that are subject to a detailed valuation regime set forth in Rule 2a-7 under the 1940 Act; see also Investment Company Act Release 9786 (May 31, 1977).

2. As is discussed later in this article, the definition of fair value in FAS 157 is broader than the definition used in the 1940 Act, because it includes all methods of valuing securities, including valuations using currently available market quotations. Under the 1940 Act, fair valuation is required only when current market quotations are not readily available.

3. An active market is one in which transactions for the asset occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

4. See Investment Company Act Release No. 6121 (July 20, 1970) on valuation of securities subject to a “shelf” registration under the Securities Act of 1953. See also, Letter of Andrew Bara, Chief Accountant of the SEC to Robert Maynard, Chairman - Committee on Investment Companies of the AICPA (December 16, 1970) on the form of audit opinion relating to fair valuation procedures.

About the Authors

John N. Ake and Martha J. Hays are partners in the Business & Finance Department of Ballard Spahr Andrews & Ingersoll, LLP. They are also members of the Investment Management Group, Private Investment Fund Group, and Securitization Group within their firm. Both work in Ballard Spahr’s Philadelphia office. The authors express their appreciation for the assistance provided by Kimberly A. Klock and John S. Rollings in preparing this article. Contact: ake@ballardspahr.com or hays@ballardspahr.com..