Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.
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Fair Valuation– Does Management Know Enough About the Process?

Most, if not all mutual fund complexes or fund accounting agents charged with valuing securities for ’40 Act mutual funds utilize a third party pricing agent. The use of an independent pricing agent does not relieve fund management of responsibility with respect to the adequacy of the prices received. Management needs to understand how the prices received from a pricing vendor are determined and have processes and procedures in place to determine that the pricing received meets GAAP requirements, namely that prices meet the standards of what a willing market participant would pay in an arms-length transaction.

Recently the Securities and Exchange Commission (“SEC”) has been conducting “information gathering” with respect to how management understands the process behind the prices. This information gathering has not been isolated to just the mutual fund world but rather has included all entities within the public company universe. With respect to mutual funds, the information is being sought as part of the financial statement review conducted by the SEC every three years under regulations defined by Sarbanes-Oxley. Below are some of the questions being asked of management. These questions and apparently the SEC’s concern and focus primarily relate to Level 2 pricing, which requires the use of observable inputs.

  • What are the vendor controls over their pricing process?
  • Has management reviewed those controls and have they documented their understanding?
  • Does the vendor have a SAS 70 or more recently a SSAE 16 document?
  • Are there any exceptions detailed in the SAS 70 or SSAE 16, and if so what has management done to satisfy themselves that such exceptions do not impact their fund(s) pricing?
  • Does management drill down into the data and understand the inputs being used?
  • Are such inputs consistent with developing prices which meet GAAP standards?
  • What does management do to gain comfort with the accuracy of the prices supplied?
  • Are there price tolerance and change parameters in place?
  • Is there a price challenge mechanism available to fund management?
  • What are the internal controls surrounding the price challenge mechanism?
  • What have been the results of price challenges and is there back testing in place to support the results of the price challenges?

Although the SEC has not stated the objective of this information gathering, it is clear that they consider it a necessity for public registrants to have effective internal control procedures and processes surrounding the independent third party pricing agent. The pricing agent will be the first to tell their clients that they are only the initial step in the pricing process. Management maintains all responsibility with respect to the accuracy and classification of prices received. If management feels that they properly address the questions being posed, then they are probably in good stead. Management that has always relied on the third party pricing agent and that has given little thought to how these prices are developed should reassess pricing policy overview.

Additionally, if not already being done, it would be prudent to educate the Funds’ Board of Directors on pricing methodology. This education should include a presentation by the third party pricing agent, as well as management’s presentation on the internal processes and procedures surrounding the pricing vendor.