ETFs in large part are regulated by a single statute, the Investment Company Act of 1940 (1940 Act). While most agree that the statute over the many years of its existence has done an admirable job of regulating ETFs (and mutual funds) and protecting their shareholders, it nevertheless contains a number of surprising provisions including how it regulates valuing the securities and other assets held by an ETF.  In no uncertain terms, it assigns that task to the ETF’s board of directors.

For the most part, valuation of an ETF’s assets is an easy task:  one merely takes the closing market price of each security and multiply it by the number of shares of that security owned by the ETF, add up all of the products of these calculations, add cash, subtract liabilities and divide by the number of shares outstanding.  If market prices are not available, use the median of the last bid/ask price.  If neither are available, use the price supplied by a pricing vendor. If a vendor’s price is unavailable or it seems off, that’s when the 1940 Act’s mandate is surprising:  the board of directors has to value the security.

One can envision a group of men and women rolling up their sleeves while sitting around a board table trying to figure out the fair value of a long list of securities for multiple funds. Thankfully for directors, in practice it works differently. Guidance in the form of a hodgepodge of SEC legal and accounting pronouncements issued over the years allows the board to delegate the fair valuation process to the adviser of the ETF, which can elicit the support of certain ETF service providers. Advisers and ETF service providers have developed an evolving set of methodologies, often complex, to fair value ETF portfolio securities. The Board then gives its blessings (or not) to the fair valuations at is next monthly or quarterly board meeting, recognizing the conflict of interest the adviser has to overvalue securities because its advisory fee is based on the assets of the ETF.

On February 21, 2020, the SEC proposed to consolidate the hodgepodge of guidance on fair valuation into a single rule:  Rule 2a-5 under the 1940 Act. While the aim of the SEC is laudable, the agency badly missed its mark based on the opinions expressed in an avalanche of comment letters it recently received from the industry. While the proposed rule keeps in place the delegation concept by permitting a board to assign fair valuation of securities to the adviser, it introduces highly prescriptive board requirements around the establishment and application of fair valuation methodologies, testing of fair valuation methodologies, and evaluation of pricing services. If adopted as proposed, ETF boards may actually end up around a table with a stack of formulas, spreadsheets and test results and remain there until they have come up with legally defensible conclusions that their valuation process meets the technical requirements of the rule.

Below is an overview of the most significant conditions of proposed Rule 2a-5 followed by critiques of the proposal voiced by the industry.

Boards must establish and apply fair valuation methodologies, taking into account the fund’s valuation risks.

This condition of proposed Rule 2a-5 drew the most heat as it would require the Board in the SEC own words to “select and apply in a consistent manner an appropriate methodology or methodologies for determining (and calculating) the fair value of fund investments, including specifying: (i) the key inputs and assumptions specific to each asset class or portfolio holding; and (ii) which methodologies apply to new types of fund investments in which a fund intends to invest.”  Commenters read this requirement to not only require a board to select the methodologies in advance (e.g., private equity investments are valued using a discounted cash flow model, options are valued using the Black-Scholes model and so forth) but questioned whether to comply with the Rule boards would have to dig deeper into the models.  For example, will boards to avoid liability have to request the specific qualitative and quantitative factors to be considered, the sources of the methodology’s inputs and assumptions, and a description of how the calculations are to be performed. Commenters urged a less prescriptive approach that would be more consistent with other duties of directors that are grounded in state laws of duty of loyalty and care.  Boards as long as they are full informed and acting in good faith should have more flexibility in carrying out their fair value duties, recognizing that fair value approaches generally cannot be scripted in advance but will vary, depending on the nature of the particular ETF, the context in which the board must fair value price, and the pricing procedures adopted by the board.  Most notably, an ETF’s investment in complex instruments typically involves various inputs or alternative approaches based on the facts and circumstances, and it is unrealistic to expect that the board is in the position to foresee and document all of these in advance.

Boards must test fair valuation methodologies.

Many commenters failed to see much value from testing fair valuation methodologies and to the extent such testing had value, it would be outweighed by the costs of the tests.  They pointed out that routine testing of a set of methodologies would be of little benefit if other methodologies were used because market conditions or portfolio conditions changed.  Such testing might become rote and the results along with other data fair valuation methodology data proposed by Rule 2a-5 likely would lead to voluminous disclosure to boards, which may obscure material, more important valuation matters.

Boards must evaluate pricing services.

Proposed Rule 2a-5 would require the Board to scrutinize pricing services including reviewing “(1) the qualifications, experience, and history of the pricing service; (2) the valuation methods or techniques, inputs, and assumptions used by the pricing service for different classes of holdings, and how they are affected as market conditions change; (3) the pricing service’s process for considering price “challenges,” including how the pricing service incorporates information received from pricing challenges into its pricing information; (4) the pricing service’s potential conflicts of interest and the steps the pricing service takes to mitigate such conflicts; and (5) the testing processes used by the pricing service.”  Commenters again noted that these requirements were too granular, especially with respect to price challenges.  Some believed that the price challenge requirement would lead to the development of a wide variety of objective thresholds to determine when pricing challenges should be initiated. They saw no need to disrupt the current give-and-take practices between advisers and pricing services, which has worked well to date in large part because it is adaptable to particular circumstances.

Boards must receive quarterly reports about the fund’s fair valuing processes and prompt reports on matters that could materially affect a fair valuation.

Proposed Rule 2a-5 would require an adviser report to the 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.”

Most commenters did not object to quarterly board reporting but many expressed deep concerns with the “prompt” reporting requirement. A common comment was that proposed Rule 2a-5 is vague when it comes to what event or situation would trigger prompt reporting is vague and too uncertain under the Rule.  In part, because of this vagueness, boards could be burdened with voluminous, detailed fair value determination-related information between board meetings, which would impose significant costs on ETF advisers with little benefit to the ETF.

Boards must “periodically” assess valuation risks of the funds.

Boards routinely asses all of the risks that a given ETF poses for investors, but not continuously. With input from the ETF’s chief compliance office, Boards perform their valuation and other risk oversights annually unless a significant valuation risk arises between annual reviews.  Commenters urged the SEC to make  clear that  valuation risk assessment should be performed annually like all ETF risk assessments within the framework of Rule 38a-1 under the 1940 Act, the SEC compliance rule.

Specified records about the valuation process must be maintained.

Proposed Rule 2a-5 requires 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. Commenters urged the SEC to scale back certain of these recordkeeping requirements. They expressed the concern that the task would be monumental for many advisers to fixed-income ETFs and funds including those that invest in thousands or tens of thousands of such securities. As proposed, the Rule would require the documents to be generated for virtually all of these securities since pricing services provide prices for them each business day.

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In the chess game of rulemaking, the next move will be by the SEC.  A reasonable approach would be for the SEC to eliminate a number of the prescriptive conditions of the rule, while providing a safe harbor to directors for those that remain.  This safe harbor would provide that a board would be shielded from liability with respect to a given fair value rule condition if it acted in good faith with the actions it took. The recent string of rulemaking from the SEC’s Division of Investment Management, which regulates ETFs, has been well-received by the industry and consumer advocates.  It is likely this streak will continue after the Division continues to grapples with its challenging rulemaking assignment.