SAN ANTONIO -- As new governance requirements officially took effect last week, panelists here at the Investment Company Institute's Tax & Accounting Conference said the proper valuation of securities and the monitoring of such processes will be one key to keeping firms out of regulatory hot water.
The chief compliance officer provision, which took effect last week on Oct. 5, is the mandate that garnered the most attention among the new set of requirements. However, new policies concerning the valuation of securities may be just as significant to many in the industry, executives said.
Under the Securities and Exchange Commission's new requirements in rule 38a-1, firms have to adopt written policies and procedures that effectively monitor for fair-value situations. The board of directors must approve of these practices. Funds must also have a launching point for valuation by establishing criteria for determining when market quotations can no longer be considered reliable. They must provide the methodology they use to determine current fair value of the portfolio and regularly review the accuracy of their methods and adjust as needed.
In its final rule, the SEC estimated that there are about 5,083 funds that will be subject to rule 38a-1. The Commission further estimated, based on filings from January 2003, it would take each fund 60 hours to document the policies and procedures of its compliance program. The estimate takes into account that a large number of the documentation being required by the rule is information the funds already maintain. Additionally, a firm may benefit from a master compliance program that sets policies and procedures for several funds under its roof.
The regulator further expects each fund to have to spend five hours a year documenting the conclusions of its annual compliance review for its board and half an hour a year maintaining copies of the compliance policies and the CCO's annual reports. Overall, the SEC expects the total hour burden on the industry to be about 333,000 hours a year.
Keeping a Close Eye
While the mandate on recordkeeping is pretty straightforward, panelists speaking here about security valuation urged firms to examine and continually reevaluate their polices as well as scrutinize those they are trusting with key cogs in their pricing procedures.
"The rule is very explicit, painfully explicit to some, that [the fund and the CCO] are responsible for the selection of service providers. It is important to have well thought out reasons for fair-value implementations, and it is critical to have everyday documentation in place," said Tony Evangelista, a partner with PricewaterhouseCoopers of New York.
Evangelista said it is imperative that firms select a service provider, or pricing agent, that is competent, has integrity and has the ability to deliver its services in a timely manner in order to comply with new regulatory mandates.
James Campbell, assistant chief counsel in the SEC's division of investment management, said firms must clearly detail their policies for monitoring vendors. "The definition of responsible parties is important, the SEC wants to make this clear, and documentation is an important element of this," he said. "The single most important factor is documentation of fair-value estimates."
Donna McManus, vice president at the Bank of New York, said firms that use outside companies or services to do their pricing could be left open to scrutiny and possible regulatory action if they fail to put a contingency plan in place. Furthermore, the methodologies by outside pricing services may not always account for company-specific events, bankruptcies, or natural disasters such as hurricanes. "Funds need to be able to account for these things," she said.
In the event of an emergency, firms need to be able to have a contingency plan. "Groups need to have some methodology in place in case the vendor's prices don't come through," said Mark Osterheld, assistant treasurer at Fidelity Investments. "It's just prudent."
When fair-value pricing, the panel said that confidence levels, triggers and trigger levels, quality-control checks, back testing, timing of foreign exchange rates and contingency planning are all areas firms need to think through from a policy perspective. Campbell defined triggers as "a determining point to decide whether the last quoted prices are reliable."
Although many firms are currently feeling out what trigger levels are appropriate in the pricing of international funds and securities, some firms are gravitating towards zero triggers. "We would expect that funds [going to zero triggers] are keeping documentation and that the fair value is the best figure for those securities," Campbell said.
Also of concern to the panelists is back testing, which is a method used to determine the accuracy of the valued price of a security compared to the next day's local open of the security. Evangelista said there are four critical elements to back testing. Firms must include some element of independently testing the results.
Funds also need to assess the methodology used for back testing and think about the process intuitively. "Don't just accept the methodology," he said. From there, it is key to act on the results and to document the whole exercise." Keeping a record of the steps taken is the "key element of the whole process" because it allows firms to provide documentation to federal regulators, if necessary.
Despite all the variances and different problems to deal with, the main focal point of the new regulation pertaining to fair value can be boiled down to one basic theme. "The single most important factor is documentation of fair-value estimates," Campbell said.