Fair Valuation And Mutual Fund Directors: The Great Valuation Divide And Its Implications

This is the third in a series of Client Alerts regarding the risks that misvalued securities pose for the independent directors1 of investment companies. The first Client Alert detailed the cases in which the SEC sanctioned independent directors for misvalued securities. These cases led to the conclusion 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. The second Client Alert reviewed how securities are valued under the Investment Company Act of 1940 (the "1940 Act"), and contrasted this with the approach taken in Accounting Standards Codification 820. This comparison showed how independent directors might benefit from the more modern approach to valuation taken in the accounting standards.

The Client Alert continues to examine why misvalued securities pose a risk to independent directors. Having reviewed the law, we now examine the facts: specifically, we consider how differences in the markets for equity and fixed-income securities affect their valuation.

The 1940 Act's requirements for valuing portfolio securities may be summarized as follows: the board of directors must determine, in good faith, the fair value of every portfolio security for which a market quotation is not readily available. A market quotation is readily available if, on the date of valuation:

The portfolio security was traded on that date; or Bid and asked prices for the portfolio security are being published by brokers; and The number of trades and published quotations do not indicate that there is a thin market for the portfolio, and circumstances do not otherwise bring the validity of the trades or quotations into question. Subject to this last condition, on any day that a portfolio security trades, its last sale price is its market quotation; otherwise, its market quotation must be a published bid price or a value in the range of published bid and asked prices.

These requirements place directors at risk whenever a market quotation for a portfolio security is not readily available. Structural differences in their respective markets result in market quotations for equity securities being more commonly available than market quotations for fixed-income securities. This "great divide" in the relative availability of market quotations helps explain why some mutual funds pose a greater risk of misvaluation than do others.

  1. Availability of Market Quotations for Equity Securities Most equity securities held by investment companies are listed on exchanges. Most listed equity securities trade every day, and market-makers and specialists regularly publish bid and asked prices for all listed securities. Normally, equity trades are brokered, which means that agents for buyer and seller negotiate to trade at a single price. Buyers and sellers compensate their brokers by paying separate commissions. Public equity trades are reported in real time over a "consolidated tape."2

    The structure of the listed equity market makes it easy for securities pricing services to compile and disseminate market quotations for equity securities as of the close of trading on each day. Pricing services can easily identify any last sale price reported on the...

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