Fair Valuing of Portfolio Securities: Responsibilities of Fund Managers and Directors

David R. Evanson

Privately Published, Winter, 2005

Fair Valuing of Portfolio Securities: Responsibilities of Fund Managers and Directors

[Introductory Quote] Accurate pricing of portfolio securities and the calculation of NAV are critical activities that are at the very heart of mutuality in mutual funds. Each shareholder, whether coming, going, or continuing must receiver his or her fair, pro-rata interest in the fund, every day. This goal can be reached only if the prices used are accurate and the net asset values are calculated correctly.

Lori Richard, Director of the SEC’s Office of Compliance Inspections and Examinations.

[End Introductory Quote]

Fair Valuations – The Regulatory Landscape
Regulatory Guidance Timeline

Section 2(a)(41) of the Investment Company Act of 1940.

Fair valuation is mandated as one of the primary responsibilities of fund directors

Rule 22c-1 Under the Investment Company Act

Securities must be valued at least once each day in calculating a fund’s NAV

Accounting Series Release 113

Guidance on valuing restricted securities at fair value due to the lack of readily available market quotations

Accounting Series Release 118

Further guidance on fair valuation and the board’s good faith fair valuation responsibilities

SEC Staff No-Action Letter to Putnam Growth Fund and Putnam International Equities Fund

The SEC Indicates that funds may take into account post-closing developments on foreign markets and may assign fair valuations to securities traded on those markets

Investment Company Act Release No. 14244

SEC expresses its view on the effect of events occurring in a foreign market between its close and the time a fund’s NAV is calculated (usually 4:00 p.m. eastern time)

SEC Interpretive Letter

Fair Valuation determinations are required in emergency of other unusual situations (e.g. in the event of a market close due to natural disaster)

SEC Interpretive Letter

Significant events must be considered in determining whether market quotes are readily available.

2004 FASB Proposal on Fair Value Measurements.

FASB seeks to establish a framework for measuring fair value that would apply broadly and would clarify the fair value measurement objective and its application under other authoritative pronouncements that require fair value measurements.

2004 Market Timing Rule.

SEC requires more disclosure regarding the circumstances under which fair valuing of portfolio securities is employed.

2005 New SEC Guidance on Fair Valuing of Portfolio Securities


The valuation of portfolio securities is the cornerstone of the investment management industry. Securities valuations represent a significant day to day responsibility for fund management and directors. Recent events involving so called market timing, increasingly interlinked capital markets and a broadening of securities held in mutual funds have brought to light new thinking and new rules about the fair valuing of portfolio securities. Whereas the regulatory landscape leading up to current practices focused on event driven application of fair value procedures, fund managers and trustees must now operate within a broader context. That is the application of fair value procedures is becoming part of a fund’s daily operations rather than a contingency procedure applied when the fund’s board and or management believes pricing or other valuation irregularities might be present.

Thus, fair value procedures are migrating from a stop gap procedure during periods of crisis or irregularity to a tool used by fund management and directors to ensure continuous accuracy of net asset value (“NAV”). This evolution has occurred as a result of changes in fund management and oversight as well as changes in regulatory orientation. As regulators lowered the bar on the materiality of events and circumstances which necessitate fair valuing of securities, fund managers have increasingly displayed a desire to engage in fair valuing of portfolio securities on a daily basis because of the operational simplicity of daily and predictable procedures.

Despite change and evolution, the goal of current practices are consistent with the original dictates of Section 2(a)(41) of the Investment Company of 1940 which mandates fair valuation as one of the primary responsibilities of fund directors.

[Callout Text to Go With Introduction] An analysis of Deloitte & Touche Fair Value surveys of fund groups shows fund companies actively anticipate regulatory guidance, and are methodical and studied in the application of policies and procedures which will help ensure compliance.
[Callout Text To Go With Introduction] [Purpose of Discussion Statement] The discussion that follows examines the role of fund management and fund directors in fair value determinations, the factors to be considered, and the process that management and directors should follow when they make fair value decisions. These considerations apply to all investment companies (“funds”) regardless of their type or investment objective and to all securities, whether foreign or domestic.
[End Purpose of Discussion Statement] [Sidebar]

Dilution – A Working Definition

Dilution can occur as a result of inaccurate securities valuations and purchase and redemption activity in a fund. If a fund’s assets are undervalued, purchasing shareholders will receive more shares than they are entitled to upon entering the fund, diluting the interests of other fund investors. If, on the other hand, a fund’s assets are overvalued, redeeming shareholders will take away more than they should receive and consequently, diminish the fund’s asset base, diluting the interests of the remaining fund investors.

[End Sidebar]

Why Fair Valuation of Portfolio Securities Matters

Appropriate valuation of securities is key to correct NAV calculation. Because the price of mutual fund shares is based on the value of the fund’s net assets, incorrect securities valuations will result in incorrect share prices causing potential adverse consequences – or dilution for fund investors.

When securities in a mutual fund portfolio are overvalued, sellers receive more than their pro rata share of the funds assets upon redemption. When the securities in a mutual fund portfolio are undervalued, buyers of fund sharers receive more than their pro rata share of the fund’s true value. In both instances, the transfer of wealth to buyers and sellers of inaccurately priced mutual fund shares occurs at the expense of existing and long term shareholders.

In theory, assigning a value to a security is a relatively straightforward exercise for exchange traded equities in the presence of “readily available” market quotations. However, mutual funds are increasingly holding securities for which accurate quotations may not be available. Small capitalization securities, high yield securities, foreign securities, municipal bonds, and distressed debt securities all pose challenges to the assignment of a fair valuation of portfolio securities.

The SEC has indicated that while fund directors are not expected to be involved in day to day valuation decisions, they play an important role in ensuring that fair value procedures become part of the fiber of fund oversight, and that fund management avails itself of fair value procedures as a tool for maintaining continuous accuracy of NAVs.

Fair Valuing of Securities: From Regulatory Mandate to Continuous Application

The heritage of regulation surrounding the fair valuation of portfolio securities, in many ways, mirrors the development of the capital markets. At first, fair valuation was simply mandated in the 1940 Act. With securities markets and the demand for mutual funds still in their formative stages, fair valuation was more a statement of principle than an operating objective.

Yet as the benefits of mutual fund investing took hold, it became necessary, in 1968, to require daily assessments of value for orderly and fair accommodation of the increasing number of purchases and redemptions. Under Rule 22c-1 mutual funds had to commence computing their NAV at least once a day, and had to be ready to purchase and redeem shares at the fund’s established NAV on a per share basis.

Rule 22c-1 was followed by Accounting Series Releases (ASR 113 in October 1969 and ASR 118 in December 1970) regarding valuing restricted securities. The necessity of such regulation reflects the maturation of the mutual fund business and the seasoning of mutual fund managers. With this maturation, new and different vehicles, such as restricted securities, became present in their portfolios. These securities presented new valuation challenges for which regulatory guidance and management oversight was required.

The 1981 SEC Staff No-Action Letter to Putnam Growth Fund and Putnam International Equities funds reflected increasingly interlocked global economies, and as a result, interlinked securities markets. To capitalize on these trends investors looked for ways to invest in overseas markets, and the mutual fund industry responded with investment products which held high proportions of foreign securities. With its’ no action letter to Putnam, the SEC staff indicated for the first time that funds may [italicize may] take into account developments that occur after the close of foreign markets, and as a consequence of these developments, may [italicize may] fair value securities traded on foreign exchanges and bourses.

As investments in foreign securities continued to grow, the SEC expressed its view more broadly with the November, 1984 Investment Company Act Release No. 14244. Specifically, the SEC said that the effect of events occurring in a foreign market between its’ close and the time a fund’s NAV is calculated could require [italicize could require] a fund to fair value securities traded elsewhere. Thus in the intervening years between the 1981 SEC Staff No Action Letter and 1984’s Investment Company Act Release, fair valuing of securities evolved from an optional activity that could be undertaken by fund management to one that could [italicize could] be required.

Interpretive letters issued to the Investment Company Institute in 1999 and 2001 represented further changes in the SEC’s view regarding fair value requirements.

The first of these, issued December 8, 1999 (the “1999 Letter”) indicated for the first time that fair value determinations were required [italicize required] in emergency or other unusual situations, such as when the exchange or market on which as security is trades does not open for trading for an entire trading day and no other market quotations are readily available.

In historical context, the catalyst for the 1999 Letter was perhaps not just the increasing linkage of the capital markets, but a recognition that such a relationship had very real, and potentially significant negative consequences for investors in the United States. For instance in October of 1997, equity markets around the world were extremely volatile. In particular, Asian and US markets experiences sharp fluctuations from October 27 to October 29, largely in response to each other’s volatility.

For US funds invested in Asian equities, the sharp volatility highlighted the gap between the Asian markets’ closing time and when US funds calculated their NAVs. The timing gap, combined with volatility raised significant pricing implications, and raised questions about whether prices from Asian exchanges represented true market values by the time US markets closed some 12 to 15 hours later.
As a consequence of this concern, the SEC issued another interpretive letter on April 30, 2001 (the “2001 Letter”). Specifically, not only were US capital markets inextricably linked with foreign markets — which raising timing issues for the calculation of NAVs in the US — but, were the market quotations in foreign markets reliable and were they “readily available”?

Parenthetically, the letter questioned the reliability of prices on foreign as well as domestic [italicize domestic] markets, which would have important future implications and become a catalyst for the continuous application of fair valuing of securities, foreign or domestic, rather than event driven application.

In the 2001 Letter, the staff indicated that closing prices may not reflect current market values (and thus may not be “readily available”) if a significant event affecting the securities’ has occurred since the close on the foreign market, but before the fund calculates its’ NAV. As a result, the SEC concluded that the closing prices on foreign exchanges may not reflect the then current market price of securities traded on those.

The staff discussed how such pricing discrepancies could result in dilution of a fund’s NAV, and the opportunity for arbitrageurs to profit at the expense of long term shareholders of the fund in declining as well as rising markets. As a result, the staff indicated that the interest of shareholders could be protected and arbitrage activity could be discouraged by use of fair value determinations for securities whose market values are not “readily available.” In the 2001 Letter, the staff concluded that funds are obligated to evaluate the availability of market quotations each day and use fair value determinations when market prices are not readily available.

The prescient speculation of the SEC in its’ 2001 interpretive letter surfaced two years later in a number of market timing abuses which were played out abundantly in the media. In April of 2004, the SEC issued new rules concerning disclosures regarding market timing and selective disclosures (the “Market Timing Rule”).
According to the rule, mutual fund companies are now required to make a number of disclosures. For some fund companies these disclosures are new while other funds already practice them. Specifically, as a result of the Market timing Rule, mutual funds must now describe the risks frequent purchases and redemptions pose to other shareholders, fund policies regarding the frequent redemptions and disclosures, actions the fund company has taken to prevent frequent purchases and redemptions, and disclose in their Statements of Additional Information (SAI) policies and procedures with respect to disclosure of the fund’s holdings.

In response to the need for further guidance on fair valuing amidst change and increasing public awareness of valuation issues, the FASB issued Proposed Statement of Financial Accounting Standards for Fair Value Measurements in June of 2004. With the pronouncement, the FASB sought to establish a framework for measuring fair value that would apply broadly and would clarify the fair value measurement objective and its application under other authoritative pronouncements that require fair value measurements.

The impetus of the Market Timing Rule was primarily disclosure, not structural reform. The New Guidance Issued by the SEC on Month, Date, 2005, provides the basis for new practices and policies so that mutual fund companies are able to dispatch their obligation with respect to the Investment Company Act of 1940 within the letter as well as the spirit of the law.

In several respects the guidance issued by the SEC amalgamates the best practices already in use by several fund companies, with the SEC’s views on fair valuing of securities in light of the evolution of the market since guidance on the topic was last issued.


Factors to Be Considered in Determining Fair Value

The SEC has indicated that the fair value of a security must reflect the amount an arm’s length buyer would, under the circumstances, currently pay for the security. Fair value determinations cannot be based on what a portfolio manager or other investment professional believe what a buyer may pay at a later time, such as when market conditions change or when the market ultimately recognizes a security’s true value as perceived by the manager or others. Similarly, bonds and other instruments may not be fairly valued at par based on the expectation that the fund will hold the investment until maturity.

In determining fair value, the SEC has indicated that the fund directors should assure that “all appropriate factors” relevant to a security’s value have been taken into account. The SEC staff has noted that when market quotations are not readily available, a fund board could, after considering all appropriate indicia of value, conclude that the most recent closing price represents fair value. A fund board could also determine that the opening price next time the security trades represents fair value.

While the information to be considered in making fair value determination is necessarily dependent upon the facts and circumstances presented, the SEC has indicated that fund boards and management should use an inclusive approach that takes into account as many appropriate factors as possible, rather than a more circumscribed analysis.

Historically, the SEC has emphasized that fundamental analytical information relating to the security (such as price and earnings ratios for equities and yield-to-maturity for debt) represent the most important factors to be considered in assigning fair value to portfolio securities.

More recently, in the 1999 Letter, the SEC staff has indicated that the following factors, while not an exhaustive list, should be considered when appropriate in making fair value decisions.

– The fair value of other financial instruments (including derivative securities)traded on other markets or among dealers;

– Trading volumes on markets, exchanges or among dealers;

– Values of baskets of securities traded on other markets , exchanges or among dealers;

– Changes in interest rates;

– Observations from financial institutions;

– Government (domestic or foreign) actions or pronouncements;

– Other news events; and

– With respect to securities traded on foreign markets, the value of foreign securities traded on other foreign markets, ADR trading, closed end fund trading, foreign currency exchange activity and the trading prices of financial products that are tied to baskets of foreign securities such as WEBs.

[Callout Text to go with Factors to Be Considered in Determining Fair Value]

Deloitte & Touche Fair Value surveys of fund groups demonstrate that the use of third party pricing vendors to fair value securities has undergone radical change. What was

once an isolated practice is now utilized by a majority of fund companies.

[End of Callout Text to go with Factors to Be Considered in Determining Fair Value]

Directors Exercise of Good Faith in Overseeing the Fair Value Process

As indicated above, Section 2(a)(41) of the Investment Company Act requires fair value determinations to be made in “good faith” by the fund’s board of directors. The SEC staff has stated that the good faith standard is a flexible concept that can accommodate different considerations. The staff has indicated, for example, that different boards for funds in the same complex, may arrive at different prices for the same securities, consistent with their good faith obligations.

In the 2001 Letter, the staff states that the good faith requirement is met when fair value determinations are the product of a “sincere and honest assessment of the amount a fund might reasonably expect to receive for a security upon its current sale, after considering all appropriate factors available to the fund. The staff also indicated that the good faith standard is met when a board continuously evaluates the appropriateness of methods used to identify situations where prices are not readily available and to determine fair value in these situations.

The staff has further indicated that a board would generally not be acting in good faith if, for example, the board knows or has reason to believe that its fair value determinations do not reflect the amount a fund might reasonably expect to receive for a security upon current sale. A board would also generally not be acting in good faith if it acts with reckless disregard for whether its fair value determinations are appropriate.

Board Approved Pricing Procedures
In satisfying the board’s good faith obligation, the 1999 Letter indicated that the specific actions a board must take will vary based upon:

– The nature of the particular fund;
– The context in which the board uses fair value pricing; and
– The pricing procedures adopted by the fund.

Recognizing that most boards are only indirectly involved in day-to-day pricing decisions, the 1999 Letter, like earlier guidance in ASR 118, suggests that the directors’ role in approving fair value pricing procedures is a very important part of the board’s food faith responsibilities. The SEC has emphasized that funds must document the fair value decision-making process and retain this information for inspection by the fund’s independent accountant. This information must also be available for inspection by the SEC Staff.

The 1999 Letter indicates that when management has developed and directors have adopted comprehensive pricing procedures, comparatively limited involvement by the directors in the valuation process is needed to satisfy the board’s good faith requirement. The 1999 Letter suggests that comprehensive procedures should include, for example, criteria for determining when market quotations are readily available and methodologies governing how fund management will make its fair value determinations, including actions that would be appropriate for particular emergency conditions and other significant events.

The SEC staff has further indicated that when a board has vested a comparatively greater amount of discretion in management or when pricing procedures are vague, greater involvement by the board is expected and must be immediate. Under these circumstances, a board may be required to evaluate whether pricing procedures are appropriate, what pricing inquiries have been made by management, what factors management is considering when making pricing decisions, how significant events (when applicable) are affecting the fund’s pricing mechanisms, and how particular securities are being priced.

The board cautioned that, when the board has approved or established limited fair value procedures, directors may need to authorize the specific pricing methodology used.

Board Monitoring Responsibilities
The SEC has emphasized a board’s continuing responsibility to monitor the appropriateness of the methods used in fair valuation. Funds should assess the availability of market quotations. They should also regularly test the accuracy of their fair value prices by comparing them with values that ate later available from other sources, including actual trade prices or next-day opening prices, as well as quotations from other pricing services and dealers.

In the 2001 Letter, the SEC staff recognized that fair value determinations may differ from the next day or actual sales of securities. The staff indicated that any such discrepancies do not necessarily indicate that the funds fair value prices are inappropriate. Rather, the fund should reevaluates its fair value methodology to determine what, if any, adjustments in the methodology may need to be made.

Valuation and Similar Committees
The board may delegate pricing decisions to a valuation committee or similar entity. Such committees can assist the full board in developing pricing methodologies on a periodic basis, as necessary. As a matter of practice, valuation and similar committees are often composed of personnel affiliated with fund management, including affiliated directors, and other management personnel often without the presence of an independent board member.

Valuation and similar committees typically respond to issues that arise between board meetings, following pricing policies established by the full board. When a valuation or other committee has acted with respect to a particular pricing issue, the best practice and the board’s good faith obligations suggest that the committee’s action(s) should be reviewed at the next regularly scheduled board meeting. This process enables the full board to understand the issues(s) that the committee considered, the actions taken, and make any adjustments in the committee’s authority or the fund’s pricing procedures as deemed necessary.


While some have question whether fund directors have the expertise necessary to make fair valuation determinations in light of today’s complex global marketplace, the SEC and its staff remain resolute in re affirming the board’s primacy in making fair value decisions. The role was assigned more than 60 years ago, and has grown, rather than diminished in importance. However, rather than making specific pricing decisions, directors are charged with bring applicable oversight to the fair valuation process. To meet this responsibility, directors should approve pricing procedures, monitor the application of these procedures, make adjustments in these procedures when necessary, ands ask questions of management in regard to the fair value process and specific fair value obligations under the Investment Company Act and their fiduciary duties to fund shareholders.

Valuation Guidance from the SEC’s Office of Compliance Inspections and Examinations