Attorney Stephen Keen from the law firm Reed Smith released a series of papers on fair valuation and mutual fund directors. The fourth in the series, released August 29, deals specifically with "Fair Valuation and Mutual Fund Directors: New Guidance from the SEC." Keen, who spoke at Crane's Money Fund Symposium in June on pending (at the time) SEC reforms, has more to say now that they are reality. "In June, I began a series of Client Alerts on Fair Valuation and Mutual Fund Directors. The third installment in the series was released in July. Although I was not certain what path the series would take, I knew where it would end -- with an irrefutable argument that it was past time for the SEC to address the use of pricing services to fair value securities, particularly fixed-income securities."

He writes, "In policy arguments, as in comedy, timing is everything. The SEC stole my punch line when it recently issued new guidance on the use of pricing services. The guidance is buried in the bowels (an apt phrase in this instance) of the SEC's July 23 release adopting money market fund reforms. A section providing "Guidance on the Amortized Cost Method of Valuation and Other Valuation Concerns" begins at page 270 of the 869-page release. The SEC tacked much of the 11 pages of guidance onto section 404.05 of the Codification of Financial Reporting Policies (CFRP)."

Keen provides a summary of the guidance. The first part is on "Previous Guidance Codified by the Release," referring to the July 23rd reforms. "Much of the guidance included in the Release is already in section 404 of the CFRP. In fact, the amount of repetition in the revised section may confuse a first-time reader. For example, subsection 404.03.b.iv (Securities Valued "in Good Faith") already stated, "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." New subsection 404.05.c.2 (Other Valuation Matters) quotes this statement verbatim, both in footnote 896 and in the sentence immediately following this footnote. Like Lewis Carroll's Bellman, when it comes to valuation guidance, "What [the SEC] tell[s] you three times is true," he writes.

The new subsection also includes guidance not previously part of the CFRP, particularly: 1) "Directors cannot delegate their statutory duty to determine the fair value of fund portfolio securities," although the SEC reaffirmed that directors "may appoint persons to assist them in the determination of such value, and to make the actual calculations pursuant to the board's direction." 2) Money market funds may not use amortized cost for purposes of "shadow pricing" their portfolios, that is, monitoring deviations of the fund's net asset value "calculated using available market quotations (or an appropriate substitute that reflects current market conditions)" from its amortized cost value. 3) Fair value cannot be based on what a buyer might pay at some later time, such as when the market ultimately recognizes the security's true value as currently perceived by the portfolio manager. Funds also may not fair value portfolio securities at prices not achievable on a current basis on the belief that the fund would not currently need to sell those securities."

He adds, "This last statement comes from the Heartland Directors Order discussed in the first Client Alert. This may be a useful reminder for attorneys to take care when negotiating offers of settlement, as they may be creating new standards for all funds and their directors."

The second part is on "Guidance Regarding the Use of Pricing Services." Writes Keen, "This new subsection of the CFRP begins by noting, "evaluated prices provided by pricing services are not, by themselves, 'readily available' market quotations or fair values 'as determined in good faith by the board of directors'.... It is important to understand that not all prices obtained from a pricing service are "evaluated prices." ... The third Client Alert also showed why market quotations are generally not available for most fixed-income securities or other securities traded over the counter. For these securities, pricing services provide "evaluated prices": prices based on the pricing service's proprietary pricing models and, typically, observable market inputs. With regard to evaluated prices, pricing services "acknowledge that they provide only 'good faith' opinions on valuation." ... As the second Alert explained, this precludes funds from treating an evaluated price as the "value" of a portfolio security for purposes of the Investment Company Act of 1940."

He continues, "Pricing services therefore must fall within the category of persons whom directors "may appoint ... to assist them in the determination of such value, and to make the actual calculations pursuant to the board's direction." In selecting a pricing service to provide such assistance, new subsection 404.5.c suggests that directors may want to consider: "the inputs, methods, models, and assumptions used by the pricing service to determine its evaluated prices;" how changes in market conditions may affect these factors; "the quality of the evaluated prices provided;" and "the extent to which the service determines its evaluated prices as close as possible to the time as of which the fund calculates its net asset value." Finally, directors have an ongoing duty continuously to review the appropriateness of the method used in fair valuing a portfolio security. Directors should not rely on evaluated prices if they do "not have a good faith basis for believing that the pricing service's pricing methodologies produce evaluated prices that reflect what the fund could reasonably expect to obtain for the securities in a current sale under current market conditions."

The third section is on "Guidance Regarding Use of Amortized Cost." Keen states, "This new subsection of the CFRP begins by discussing money market funds in particular, but then refers to the possibility that "managers of floating NAV money market funds may have an incentive to use amortized cost valuation whenever possible in order to help stabilize the funds' NAV per share." Apparently, the SEC intends for the new guidance in this subsection to apply to all mutual funds that use amortized cost as a fair value.

Finally, Keen discusses the "Implication for Independent Directors." He explains, "As noted in the introduction, an in-depth discussion of this new guidance must await further Client Alerts. Nevertheless, it is possible to make a few superficial observations. First, directors should review their existing policies and procedures for determining the fair value of securities. Directors should consider whether revisions to these policies and procedures might be necessary to: 1) Avoid any implication that the board of directors has delegated its responsibility to fair value securities to a pricing service, a valuation committee or any other person. 2) Explicitly treat evaluated prices from pricing services at inputs into fair values, rather than as fair values "by themselves." 3) Conform the process for selecting and monitoring pricing services to the new guidance. 4) Identify any difference between the time as of which a pricing service determines its evaluated prices and the time as of which a fund calculates its NAV. 5) Require the daily shadow pricing of all securities with remaining maturities of 60 days or fewer valued at amortized cost."

Keen concludes, "Regarding this last point, insofar as non-money market funds typically hold small amounts of securities with remaining maturities of 60 days or fewer, directors may want to consider simply using the shadow price of these securities, rather than amortized cost, as their fair value <b:>`_. Second, directors should request a review of current disclosures regarding their funds' fair valuation process. Such disclosures should not imply that the board of directors has delegated its responsibility to fair value securities or that evaluated prices are market quotations. Finally, if they have not done so already, directors should study the "inputs, methods, models, and assumptions used by" their funds' pricing services. This is a necessary step for assessing the feasibility of independent directors complying with the SEC's new guidance on fair valuation."

In other news, JP Morgan launched a new RMB money market fund in China, according to The Asset, an Asian investment publication. The article says, "J.P. Morgan Asset Management (JPMAM) has launched the China International Fund Management's (CIFM) second renminbi money market fund for institutional investors in China. Following the successful launch of their first institutional money market fund (MMF) in China in 2005, CIFM, a joint venture of JPMorgan Asset Management (UK) and Shanghai International Trust Co., has again leveraged the platform of JPMAM's short-term fixed income investment arm J.P. Morgan Global Liquidity (JPMGL)." The Asset article goes on, "The IPO raised more than 620 million renminbi (US$100 million) from over 200 initial institutional investors and the fund opened to institutional investors in China for regular investment on August 27 2014."

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