Recommendations outlined in the Securities and Exchange Commission's April 30 valuation letter will create logistical challenges for small- and mid-sized fund companies and raise questions as to when fund boards should use fair value pricing, according to industry lawyers and observers.

The letter, written by Douglas Scheidt, associate director and chief counsel for the SEC, addresses valuation issues relating to when funds should establish fair values for securities instead of relying on market quotations. The letter was written to address questions and issues raised by a similar valuation letter the SEC issued in 1999. But, the most recent letter raises a new set of questions and problems, lawyers said.

The question of when to use fair value pricing is especially relevant to funds that hold foreign and thinly-traded securities because accurate market quotations for those types of securities are more difficult to attain due to different time zones and lack of current prices.

Foreign securities prices can be drastically affected by external events that occur between the time the market on which the securities trade closes and the time that a fund calculates its net asset value, the letter said.

Funds need to closely monitor foreign markets in which they hold securities and if an event occurs that is likely to have an impact on a security's value, they must factor those events into the price of the security using fair value pricing methods, according to the letter.

The SEC's valuation letter provides more detail on how the SEC wants funds to handle valuation issues than it has in the past, but it raises several questions as well, said Barry Barbash, a partner with Shearman & Sterling of Washington, D.C. and former director of the SEC's division of investment management.

While the letter states that funds should establish pricing procedures, maintain records of when fair valuations are used and constantly monitor market quotations and international events, it does not provide much detail on how funds should price securities in certain situations, he said.

"Although procedurally oriented, the letter doesn't say how you price in certain market disruptions," he said.

Establishing those procedures and monitoring worldwide events and price fluctuations in foreign securities will provide a logistical challenge for small- and mid-sized firms, said Tony Evangelista, a regulatory compliance consultant with PriceWaterhouseCoopers of New York.

"Logistically, this is not a slam dunk," he said. "This will cause some firms to rethink their process on monitoring the valuation of illiquid and thinly-traded foreign securities. This letter provides them the basis on which to rethink those methodologies."

Modern communications technology should make it easy for fund companies to monitor world markets around the clock, the SEC said in its letter.

"Some funds have established milestones or trigger points which also may signal that significant events have occurred since the close of the foreign exchange or market on which their portfolio securities trade, such as a certain percentage rise or fall in the value of a basket of foreign securities that trade on another market, or a certain percentage change in a foreign index," the letter said.

But many small- and mid-sized fund companies will have difficulty complying with the SEC's recommendation because of the expense involved in monitoring world events and each individual security, Barbash said.

"I think there is a cost factor to go through the monitoring," he said. "Every time you go through more processes, there is a cost involved and when [smaller firms] say it will be more costly, I don't think they are telling a lie. But I don't think the SEC finds that a compelling argument."

The SEC letter also creates ambiguity on how the SEC wants fund boards to proceed with fair value pricing, Barbash said.

The most recent letter addressed questions raised by the previous letter in which the SEC established a "good faith requirement" for fund boards using fair valuations.

"In our view, a board acts in good faith when its fair value determination is the result of a sincere and honest assessment of the amount that the fund might reasonably expect to receive for a security upon its current sale, based upon all of the appropriate factors that are available to the fund," the most recent letter states.

The letter further states that a board is not considered to be acting in good faith if, "it acts with reckless disregard for whether its fair value determination reflects the amount that the fund might reasonably expect to receive for the security."

While the SEC defines what it considers to be "sincere and honest" very succinctly, its definition of "reckless disregard" is subjective and open to interpretation, Barbash said. Fund directors need to understand that even though their intentions in using fair valuations may be "sincere and honest," they can still run afoul of the SEC, Barbash said.

Another issue raised in the letter is fund boards' obligations in monitoring foreign securities' valuations, according to Paul Dykstra, a lawyer with Gardner, Carton, & Douglas of Chicago.

The SEC's letter is useful because it endorses fund boards' interventions on security valuations and even provides guidance on when they should consider doing so, but it also raises as many questions as it answers, he said.

As technology creates global ties between markets, securities will eventually trade on global markets 24 hours a day, he said. The question then arises, How does a board justify price discrepancies between two different global markets and when, for instance, does an event in Tokyo affect a security's price in London?' Dykstra said.

Regardless of remaining questions and cost concerns, all funds need to comply with the letter's recommendations because the SEC is closely watching the issue, Barbash said.

"I believe this will be a top of the list item on inspections," he said. "This should serve as a wake-up call to the industry that the SEC means business on pricing procedures."

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