Pricing services play critical role in securities valuations under SEC rule

Pricing services face scrutiny from investment managers as the US Securities and Exchange Commission’s (SEC’s) new 2a-5 ‘fair value’ rule takes effect. Here, Refinitiv’s Joseph Hayek explains how pricing services should prepare for the surge in customer requests regarding pricing and data transparency

Joseph Hayek, Refinitiv

In December 2020, the SEC adopted fair value rule 2a-5 – Good Faith Determinations of Fair Value. The rule has sharply focused on the relationship between investment managers and pricing services.   

The 200-page rule under the Investment Company Act of 1940 establishes a comprehensive regulatory framework for “good faith” fair valuations of investments for which there are no readily available market quotations. The rule seeks to ensure a consistent framework and comprehensive guidance for the valuation of a fund’s securities, with three key areas: the role of the board of directors, valuation practices and pricing services.  

“Along with previously implemented accounting rules ASC [Accounting Standards Codification] 820 and IFRS [International Financial Reporting Standard] 13, which are prescriptive of how to determine fair value, rule 2a-5 completes the fair value aspect, by providing a principles-based approach and adding a compliance framework,” explains Joseph Hayek, compliance and controls officer for Refinitiv Evaluated Pricing Service. “Prior to the rule, investment firms relied on a patchwork of no-action letters, SEC staff statements and releases.” 

Also, prior to the rule, pricing services remained outside of the regulations. Their prevalence in the industry – combined with the price dislocation observed between the services’ prices and market transactions during the financial crisis that began in 2007–08 – may have prompted a change of heart from the SEC. 

“The critical role that pricing services play in valuing securities held in funds and the high reliance on them by the industry is, I believe, why they ended up in the rule,” Hayek says. “Essentially, we’ve become a de facto extension of the investment industry.”

Implications for investment managers  

The implications of the rule for investment managers and pricing services are extensive, as demonstrated by the substantial demands from the SEC. 

Holding the board ultimately responsible for fair valuations is one striking aspect of the rule that was not explicitly expressed. While the board can designate the investment adviser to perform fair valuations, it must still have “active oversight” to ensure that fair valuations for securities are performed in good faith. 

“That’s key. The board needs to ensure there is transparency and objectivity in addressing valuation risk, and a strong framework for reviewing and testing methodologies. It should adopt robust policies and procedures, periodic reporting to the board and the oversight of pricing services,” Hayek says. “This also includes extensive record-keeping requirements on determining fair value, where the SEC created a separate rule: 31a-4. Each of these categories can be quite extensive and will need to be assessed to determine how they can be applied to the firm’s overall pricing process.”

With the likelihood that the investment adviser is designated by the board to manage the valuation process, the valuations teams and compliance staff will bear much of the burden in implementing the rule and ensuring ongoing compliance.

Implications for pricing services  

The rule has shifted certain responsibilities in providing fair valuations in good faith to pricing services, although ultimate responsibility resides with the board. “As part of their oversight capacity, investment managers will further scrutinise pricing services by reviewing methodologies, models, inputs and assumptions used to derive a price. They will probe their third parties as to how they arrive at pricing decisions,” says Hayek. 

“Every price needs to be derived in a transparent, reasonable manner. Even certain inputs such as quotes from broker-dealers need to be verified for reflecting actual value at that point in time. This is what I call defensible pricing. Although uncommon, a pricing error can materially impact a client’s net asset value and require escalation to the board within five business days per the rule. The pricing service will bear some of the burden with further client requests.” Hayek adds: “It is imperative that any service has a controlled environment to address incidents, promptly respond to challenges and manage operational risk to ensure regulated clients are protected.”     

Pricing services are starting to feel the effect of this new rule. According to Hayek, there has been a noticeable surge in price challenges and deep-dive analysis requests, which is expected to continue. Additionally, client due diligence meetings are becoming more detailed, and some clients have requested quarterly meetings to discuss any changes that may have taken place during the period. 

Ahead of the rule’s implementation next year, Refinitiv is working closely with customers to understand their needs. Refinitiv is reviewing its processes to increase efficiency in areas it expects will be affected by the additional demands. These include price challenges and deep-dive requests and plans to provide additional price transparency and key performance metrics.

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About Refinitiv

Refinitiv, an LSEG (London Stock Exchange Group) business, is one of the world’s largest providers of financial markets data and infrastructure. With $6.25 billion in revenue, more than 40,000 customers and 400,000 end-users across 190 countries, Refinitiv is powering participants across the global financial marketplace. It provides information, insights and technology that enable customers to execute critical investing, trading and risk decisions with confidence. By combining a unique open platform with best-in-class data and expertise, Refinitiv connects people to choice and opportunity – driving performance, innovation and growth for customers and partners.

 

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