Statutory Valuation Guidelines

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It is important to distinguish between price and value. These two concepts do not always have to agree. For example, an investor purchasing an asset believes that the asset's value exceeds its current price. The converse holds for an investor selling an asset. For liquid markets, prices reflect the current market consensus view regarding value. Since the bid/ask spread for liquid assets is typically small, there is a narrow confidence interval around the market consensus of economic value.

For less liquid markets, this condition does not hold. These markets are characterized by wide bid/ask spreads, suggesting less market consensus regarding economic value. A statistician would describe this situation as being one in which there is a wide confidence interval around the true economic mark. By definition, every point on this wide interval is possible. Hence, if a subsequent transaction takes

2In the case of mutual funds, the proper fair value of the assets (often hundreds of security positions), as represented by the NAV, needs to be determined on a daily basis within a few hours, which creates operational and logistical challenges. As we will see, to get this right, the devil is—as is often the case—in the details.

3For example, if a fund's NAV is understated and a new investor joins the investment pool, existing investors are inadvertently forced to give up a part of their wealth to the new investor. The same is true when a fund investor redeems and the NAV happens to be overstated.

place at a price that is different from the established mark, it does not necessarily follow that the mark was "wrong." In fact, given the width of the confidence interval, the mark may still have been appropriate.

The policy issues raised here are how to appropriately price an asset that has a fuzzy market consensus view as to its value. For liquid markets, price and value tend to converge on the same number. Hence, pricing feeds received from numerous vendors should yield the same result. This condition does not hold for less liquid markets which are characterized by a divergence between price and value. In such cases, there is a need for judgment to determine the most appropriate pricing given all relevant factors. As we will show later, such judgments are most credible when they are applied by professionals who are independent of the portfolio management process in both fact and appearance.

In establishing valuation and pricing policies, it is important to review best industry practices, industry regulation, and government regulation. The long established and highly regulated mutual fund arena is a very good starting point for reviewing valuation policies. Even if for other market segments such as hedge funds and institutional separate accounts there is less formal guidance, the mutual fund-related rules could help define the general framework of best practices across all investment management products.

The fundamental rules governing valuation of portfolio securities for mutual funds are set forth in Section 2(a)(41) of the Investment Company Act of 1940 (the 1940 Act), which defines the "value" of fund assets in terms of a simple dichotomy:

■ Securities "for which market quotations are readily available" are to be valued at such quotations or prices.

■ All other securities are to be priced at "fair value as determined in good faith by the board of directors."

Various SEC regulations reiterate these statutory standards. In 1969 and 1970, the SEC became concerned about the appropriateness of fund valuation practices and issued accounting releases that offer guidance on proper valuations. ASR 1134 principally addresses valuation practices with respect to restricted securities, but also offers guidance on certain other aspects of the valuation process. Then, ASR 118 deals with the use of fair value methodologies to price securities and sets forth the general principle that the fair value of securities "would appear to be the amount which the reasonable expect to receive upon their current sale." Under ASR 118, funds were instructed "generally" to use the last quoted sales price at the time of valuation. For securities that are listed on more than one exchange, ASR 118 indicates that funds should use the last sales price from the exchange on which the security is principally traded and that the last sales information from the other exchanges should be used only when there are no trades reported on the primary exchange on that date. When there is no quoted sales information, ASR 118 contemplates the use of bid and ask prices quoted by broker-dealers. Best practice is to obtain quotes from multiple dealers "particularly if quotations are available only

4Accounting Series Release No. 113, Investment Company Act Rel. No. 5,847 (1937-1982 Accounting Series Release Transfer Binder), Fed. Sec. L. Rep. (CCH).

from broker-dealers not known to be established market makers in that security." Securities laws put the onus on fund directors to ensure that funds price their holdings properly. ASRs 113 and 118 remain the primary SEC authority on permissible valuation practices.

Recent SEC staff guidance in 1999 and 2001 has focused on funds' obligations to monitor for "significant events" and to determine when market quotations are not "readily available," thereby triggering the obligation to employ fair valuation procedures in determining the value of portfolio securities.

Documented and Ratified Valuation Procedures and Valuation Authorizations

At first blush, it would seem to be a relatively simple matter to determine a security's price value at a given point in time. In practice, this process is often quite complex and subjective, however. Valuation determinations frequently involve a significant amount of judgment, ranging from the selection of pricing sources to decisions as to when, and on what basis, to override pricing data obtained from those sources.

Having formalized documented policies and procedures in place is a fundamental aspect of any consistently applied high-quality valuation process. These policies and procedures help ensure that controls exist around judgments applied to pricing and that the proper control and supervisory structure over such judgments is in place. For example, during examinations of mutual funds, the SEC staff often reviews funds' valuation policies and procedures to validate the presence of this kind of control environment. The importance of adequate supervision and control was highlighted, for example, by the SEC censure of an investment advisor for failing to adequately supervise the pricing practices of one of its portfolio managers. The SEC's order indicated that the advisor had no written procedures to implement the Fund's policy to use bid side market value prices for valuing securities. The firm's practices concerning the daily pricing were insufficient in that they, among other things, gave too much control over the pricing process with little or no oversight by anyone in a supervisory capacity. In addition, there was no procedure in place to alert [the advisor] when bid side market prices were not available. [The advisor] did not independently verify the daily prices provided to [the advisor's] accounting department with the pricing source or any secondary sources.5

Valuation procedures need to cover various dimensions that should be considered in defining the "right" price. Among these are:

■ The parameters for data collection and computation. For example, such procedures should establish criteria for determining when securities are considered to have readily available market quotations and when fair value is required.

5Van Kampen American Capital Asset Management, Inc., Investment Advisers Act Rel. No. 1,525, 60 SEC Docket 1,045 (September 29, 1995).

■ Identification of acceptable sources of pricing information and methodologies for each asset type held by a portfolio.

Pricing date and time (e.g., 4:00 p.m. Eastern time, close of New York Stock Exchange, 4:00 p.m. Central time, previous day close, etc.). Pricing type (e.g., bid versus ask versus mean versus close versus last sale; pricing location (e.g., price from exchange where principally traded, global listings, etc.).

Pricing methodologies for over-the-counter (OTC) or illiquid securities with no current price transparency (e.g., matrix pricing, broker quotes, model valuations, etc.).

Pricing override/manual price procedures.

■ Specification of the types of reports, automated flagging systems and other controls to be applied to the initial pricing information in order to ensure accuracy and reliability. Further, pricing override and manual pricing procedures should be documented.

■ Determination of the portfolio management/senior management to whom valuation issues should be reported, as well as specification of the circumstances under which supervisory approval and/or board action is required.

■ Finally, fair valuation policies, which determine under what circumstances an obtained price still reflects fair value, or whether an alternative pricing mechanism is to be used.

Positions Marked by Independent Accounting Agents

Valuations are, among other things, used to determine asset manager compensation. Valuations affect both the size of assets under management on which fixed fees are paid as well as reported portfolio performance on which incentive fees may be earned. In order to avoid conflicts of interest in either fact or appearance, pricing responsibility should lie with a team that is removed from and independent of portfolio management and the investment process. In general, segregation of duties in valuation matters is a clear best practice and a necessary but not sufficient condition for an effective internal control environment.

parties that are independent of the investment process such as operations or investment accounting departments, or possibly even outsourced accounting agents, are examples of professional teams that can provide this necessary independent oversight of pricing. It is, of course, critical for the valuation process to have appropriately qualified staff that exhibits a sound knowledge of the financial products to be priced. Commercially available accounting agents with their own internal con-trols6 can act as the first line of defense for the verification of pricing data. Comparisons of prices across sources, tolerance levels for day-to-day price movements, and comparisons to related securities from the same issuer are some of the sanity checks that can be built into the pricing process of an accounting agent. As we will see in

6Often documented in Statement on Auditing Standards No. 70 (SAS 70)/Financial Reporting and Auditing Group (SAS70/FRAG21)—Reviews.

greater detail, the work of these agents can and should be further supplemented by professionals within the firm ultimately responsible for the investment product.

Wherever possible, prices should be sourced from independent parties like pricing vendors or stock exchanges. For some products such as OTC derivatives, broker quotes might get sourced from the trades' counterparties in addition to unrelated counterparties. Where fully independent price sources aren't available, separate price verification will be required to help mitigate any risks of mispricing.

Separate Valuation Oversight and Price Verification

It is a best practice to establish an independent (i.e., independent of portfolio management) and separate valuation oversight function that monitors the various aspects of the valuation policies and procedures and ensures continuous focus. This team should coordinate the valuation processes across different functions, perform an oversight of the pricing processes, and regularly assess the quality of the pricing used (price verification). If, as an exception,7 portfolio valuations need to be generated or obtained by the investment advisor, the independent valuation oversight team should play an active role in ensuring that such valuations are reasonable and appropriate. When all is said and done, this team should be deemed as ultimately and solely responsible for the fairness of pricing used.

In an enforcement procedure involving a bank serving as a fund accountant for a money market fund, the SEC alleged that the bank lacked adequate controls because an employee improperly treated a significant drop in securities prices as a transmission error and manually overrode it. The SEC order indicated that, among other things, there was no oversight or review of pricing deviations by senior management, and no control or "flags" were put in place to alert senior management.8

Management Reporting and Valuation Committee

The establishment of a valuation committee with senior management representation emphasizes the importance of the valuation control function. In addition to being a senior supervisory body, the valuation committee acts as a discussion forum and decision maker on any related topics. Representation should cover control functions such as risk management, legal, compliance, and controllers, as well as senior management. It should ensure that policies and procedures exist for reliable and accurate pricing, that an independent valuation oversight group exists to execute these procedures and policies, and that such group is independent of portfolio management and is adequately trained and funded. Finally, this committee should ensure that it is informed in a timely manner of all material judgments involving valuation practices.

Reporting to this committee should be the valuation oversight group comprised of professionals charged with the responsibility of executing the policies and stan

7For example, for the case where no external quote could be obtained or the obtained price was deemed no longer accurate.

8In the Matter of the Bank of California, N.A., Investment Company Act Rel. No. 19,545, 54 SEC Docket 989 (June 28, 1993).

dards of the valuation committee. We now explore the valuation oversight group in greater detail.

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