Rule 38a-1, under the Investment Company Act of 1940, commonly called the “Compliance Rule,” identifies the investment adviser, principal underwriter, administrator and transfer agent as the “significant” service providers to a mutual fund. The Rule further states that a due diligence review of the policies and procedures should be completed for these service providers at least annually. Fund compliance officers and fund boards are now quite accustomed to this process.
Another Significant Service Provider
But what about the pricing vendor of a mutual fund – is the pricing vendor a significant service provider? The short answer is “Yes”. In recent years, through enforcement actions and guidance (most notably the Morgan Keegan enforcement action*), the SEC has made a clear case that pricing vendors are important service providers. Funds using pricing vendors that provide evaluated pricing services for asset classes such as bonds and derivatives especially rely upon the vendors for daily valuation. The SEC has also reemphasized the valuation structure that each mutual fund should have: delegation to individuals and service providers to assist with pricing is permissible, but the ultimate responsibility still lies with the board. So, although not specifically noted in Rule 38a-1, the pricing vendor should be considered a significant service provider and thus should be reviewed at least annually.
The monitoring of prices provided by a pricing vendor is an integral part of the oversight process. Valuations provided by pricing vendors should be reviewed on a regular basis for accuracy and reasonableness. In many cases the fund accountant or fund administrator has the day to day interaction with the pricing vendor. Investment advisers should consult with the fund accountant or fund administrator regarding their interactions with the pricing vendors and any items of note. Many pricing vendors offer the ability to challenge the vendor’s evaluated prices. The investment adviser can submit documentation justifying the challenge to the vendor and the information will be reviewed. The vendor will then either confirm its original price or adjust the price. The price challenge process is an important step to help ensure the pricing vendors have all relevant information for the price evaluation process.
Following a Process & Key Items to Request
The annual due diligence process for pricing vendors is generally very similar to other service providers of a mutual fund. Due diligence may be carried out by a variety of departments, including investment management, fund accounting, fund administration, or even compliance and risk, depending upon the organization’s size, complexity, and available resources. For example, Ultimus assists its clients in their obligations by conducting a pricing vendor due diligence process through the efforts of the Fund Compliance department, including Ultimus employees serving as fund CCOs, and the Fund Accounting department. Ultimus also coordinates conference calls with clients and personnel from pricing vendors to discuss the vendor’s operations and services.
The annual due diligence process should include a questionnaire and document request list. Here is a list of common items to request and areas to review as part of the due diligence, as applicable:
- Description of the methodologies used for various asset classes
- SOC 1, SSAE 16 or similar controls report specific to the evaluated pricing service
- Compliance structure and background
- Summary of policies and procedures
- Pricing and evaluation process
- Evaluators’ experience and infrastructure
- Price challenge process
- Fair valuation process for securities traded on a foreign exchange
- Summary of cybersecurity and data security programs
- Summary of disaster recovery/business continuity plan
Periodic on-site visits of the pricing vendor’s office are also a common best practice. Another best practice is to have the pricing vendor provide a presentation to the mutual fund board or the organization on a periodic basis discussing some of the same topics noted above. This will allow the board or firm to have direct interaction with the vendor and provide them an opportunity to ask questions. The direct interaction with the fund board will be reflected in the board meeting minutes. And if the topic happens to become a part of an SEC regulatory exam, the board presentation supports that a robust due diligence process is in place. Keep in mind that the board presentation is normally in addition to, not in place of, the annual due diligence questionnaire and document request list.
While there are many approaches that can be taken to conduct due diligence, this information should provide a good starting point and examples of some industry best practices. Of course, any review should be tailored to the specific services provided by the pricing vendor and how they apply to the mutual funds that are receiving the services.