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In Fair Value Pricing, Confusion Reigns


The mutual fund industry is confused. Earlier this year, the Securities and Exchange Commission wrote a letter to the Investment Company Institute in order to clarify its position on fair value pricing, but the letter actually raised more questions and has left fund firms struggling with what procedures implement, according to industry executives.

And not only has the SEC begun focusing on fair value pricing procedures, but, following several high profile enforcement actions, investors are now more aware about the issue than they used to be.

The SEC's recent focus has dealt largely with foreign markets. The April 2001 letter to the ICI focuses on how "significant events" in foreign markets can create arbitrage opportunities, which hurt long-term shareholders. One of the letter's main points is that because a security's closing price on a foreign market might be as much as 12-15 hours old when a fund's NAV is calculated, it might not reflect the true market value, especially if a significant event has occurred.

A More Narrow Interpretation

The letter tells funds to "continuously monitor for events that might necessitate the use of fair value prices" and that they must use fair value pricing whenever necessary. This is a enormous change from the SEC's previous position, said Mercer Bullard, founder of Fund Democracy and former assistant chief counsel at the SEC. Previously, if a fund had a foreign closing price of a liquid stock, it could use that price regardless of what happened. The new policy is a stricter interpretation of the 1940 Act.

"They argued that they were not taking a new position, that they were just clarifying their old policies, and that's just flatly false," said Bullard.

One of the problems funds are having with the new policy is that it is not always feasible to constantly monitor world events, assess their impact and adjust the price of securities, said Robert Zutz, a partner at Kirkpatrick & Lockhart, which represents 21 of the 25 largest mutual fund complexes.

How to Proceed

"A lot of my clients are unsure of how to proceed," said Zutz. "One of my clients asked, What the heck are we supposed to do? We have an international fund that's managed in London and invests in Tokyo, Hong Kong, all over the world. If something happens at 2 p.m. here, it's not like the London guys will be in the office. They're the experts. How do we do that? What are we supposed to do?' There are just a lot of unanswered questions remaining."

Another problem with the SEC's recent letter and its policy is that it does not allow discretionary pricing, Bullard said. According to the letter, even a security that has almost no effect on the NAV of a fund because it represents a tiny fraction of the fund's assets has to be fairly valued, he said.

"That makes no sense," Bullard said. "That doesn't help investors and it imposes unnecessary costs on the funds."

The letter has also raised a lot of questions regarding what actually constitutes a "significant event" and when fair value pricing should be used, said Elizabeth Krentzman, national director of the investment management regulatory practice for Deloitte & Touche. The SEC is purposely vague about it. The letter gives examples of events that could have an effect on prices, such as large fluctuations in domestic or foreign markets, natural disasters, armed conflicts, or governmental actions.

Of those, what has been the most difficult for fund companies to get a handle on are effects of market fluctuation, said John Capone, partner with Arthur Andersen's asset management practice. Also, the triggers are going to differ depending on what market and what type of security a fund is invested in according to Richard Hisey, senior VP at the Bank of New York.

Knowing Your Trigger

"We didn't feel that this was an appropriate area for us [to outline]," said Evan Geldzahler, special counsel in the SEC's division of investment management. "There is such a variety, we didn't think we had the expertise to say: this is a trigger."

Investors are largely unaware of funds' fair valuation practices, but the recent attention to the issue (see sidebar) is changing that somewhat, and investors are beginning to care about it, Capone said.

There has been a much higher emphasis on telling investors what fair valuation procedures are in place. Because fair valuation affects a certain group of funds-highly volatile funds with illiquid underlying securities-firms have begun sending out information on their procedures or pointing them out in prospectuses for funds that are most likely to be affected, Capone said.