Fair Valuation And Mutual Fund Directors: Alternative Approaches To Valuation

In a previous Client Alert, I analyzed six published SEC enforcement cases I found naming independent directors1 of an investment company as respondents. Of those six cases, five resulted in the SEC finding that an independent director violated federal securities laws and, of those five, four involved misvalued securities. Based on this analysis, I concluded that misvalued securities represent the greatest enforcement risk for independent directors, particularly for directors of small, stand-alone investment companies and for directors of investment companies with large, fixed-income holdings.

Directors' legal responsibilities for valuing portfolio securities is a logical place to start an examination of why misvalued securities pose a risk to independent directors. This Client Alert therefore considers the definition of "value" in the Investment Company Act of 1940 (the "1940 Act"), and highlights some shortcomings of this definition by comparing it with the more modern approach to defining "fair value" in financial reports.

  1. "Value" under the 1940 Act

    Section 2(a)(32) of the 1940 Act defines a "redeemable security" as "security, ..., under the terms of which the holder, upon its presentation to the issuer ..., is entitled (whether absolutely or only out of surplus) to receive approximately his proportionate share of the issuer's current net assets, or the cash equivalent thereof."2 Rule 2a 4 defines "[t]he current net asset value of any redeemable security issued by a registered investment company ...." With respect to portfolio securities, Rule 2a 4 incorporates the definition of "value" provided in section 2(a)(41)(B) of the 1940 Act:

    (i) with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors.

    Under section 404.03.b.ii of the SEC's Codification of Financial Reporting Policies, a "market quotation" means either (a) "[i]f a security is traded on the valuation date, the last quoted sale price" or (b) if the security is not traded on the valuation date, a value in the range of "published closing bid and asked prices." Such "published" prices are the prices at which a broker has offered to purchase (a "bid price") or sell (an "asked price") the security up to some specified amount. If multiple brokers make a market in the security, the published prices may reflect the highest bid and lowest asked-price available, even if the prices are from different brokers, or an average of the bid and asked-prices available, so long as the fund values the security below its asked price.

    With respect to "fair values," the SEC has provided the following guidance:

    As a general principle, the current "fair value" of an issue of securities being valued by the board of directors would appear to be the amount which the owner might reasonably expect to receive for them upon their current sale.3

    The 1940 Act's definition of "value" imposes a strict dichotomy: if a market quotation is readily available, it must be used to value a portfolio security; otherwise, the board of directors must determine the security's fair value. The SEC has given investment companies some leeway, however, in deciding when a market quotation is "readily available." According to the SEC:

    If the validity of the quotations appears to be questionable, or if the number of quotations is such as to indicate that there is a thin market in the security, further consideration should be given to whether "market quotations are readily available." If it is decided that they are not readily available, the security should be considered one required to be valued at "fair value as determined in good faith by the board of directors."4

    This guidance uses the term "readily available" to recognize that there may be differences in the quality of market quotations. Not all transactions may represent equally reliable indications of value. For example, if numerous stores offer an item at the same...

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