Crisis Planning: A Case Study
Mutual Fund Directors Forum Webinar SeriesFebruary 18, 2016
Barrington Partners
Hubbard Garber, Managing Director Judith Benson, Partner
Vedder Price
Bruce A. Rosenblum, Shareholder
The Backdrop
1. This conversation and accompanying white paper are focused on processes and procedures at a fund company level.
2. The backdrop for these events involve the following:
a. Over a weekend in August 2015 a patch was applied by the technology company supporting a large mutual fund service provider. The patch was applied prior to the completion of the weekly back-up cycle, which impacted the prior week’s data.
3. Introduction
a. The US mutual fund industry performs a complex process to determine the Net Asset Value (NAV) of each mutual fund/class in less than 4.5 hours every day the US markets are open. US markets close at 4:00 pm ET and NAVs are due to
NASDAQ by 8.30 pm ET.
b. Most large intermediaries require that NAVs be submitted to them earlier.
c. Given the intricacies of the process, it is impressive that the industry suffers few failures to deliver correct NAVs.
d. This research involves the failure of an accounting system over five days, the
downstream impact on fund companies and intermediaries, and their handling of the situation. This research also considers the differences between what firms ‘think they should do’ and what firms in the midst of the situation found they ‘needed to do’ to manage each day in an extraordinary week.
THE BACKDROP
© 2016 Vedder Price
What Is NAV?
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Net Asset Value (NAV) is the value of a fund’s assets minus its
liabilities, divided by the number of fund shares outstanding
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Section 2(a)(41)(B) of the 1940 Act
Value, with respect to assets of registered investment companies…means, as
used elsewhere in this title, (i) with respect to securities for which market
quotations are readily available, the market value of such securities; and (ii) with
respect to other securities and assets, fair value as determined in good faith by
the board of directors
When Is NAV Calculated?
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Rule 22(c)-1(b)(1) of the 1940 Act
An open-end fund must compute its net asset value at least once daily, Monday
through Friday (except on holidays and other specified events
)
The board of directors shall initially set the time or times during the day that the
current net asset value shall be computed, and shall make and approve such
changes as the board deems necessary (typically at the close of the NYSE)
© 2016 Vedder Price
NAVs for Mutual Funds
•
Processing redemptions and purchases
Rule 22(c)-1(a) of the 1940 Act (Forward Pricing)
Shareholders who purchase or redeem shares must receive the next-computed
share price following the fund’s receipt of the transaction order
For example, orders received prior to 4 pm receive the price determined that same
day at 4 pm; orders received after 4 pm receive the price determined at 4 pm on the next business day
NAVs for ETFs
•
ETFs
Unlike mutual funds, the retail price of ETF shares are determined primarily by
the market trading on an exchange rather than NAV, but Authorized Participants
(APs) purchase block shares of ETFs using NAV
ETF exemptive orders generally require an ETF to calculate and publish NAV
daily
As a trading guide, intraday NAV (iNAV) is calculated by the listing exchange
© 2016 Vedder Price
•
Section 22(e) of the 1940 Act
No registered investment company shall suspend the right of redemption, or postpone the
date of payment or satisfaction upon redemption of any redeemable security in
accordance with its terms for more than seven days after the tender of such security to the company or its agent designated for that purpose for redemption, except—
•
(1) for any period (A) during which the New York Stock Exchange is closed other than customary week-end and holiday closings or (B) during which trading on the New York Stock Exchange is restricted;•
(2) for any period during which an emergency exists as a result of which (A) disposal bythe company of securities owned by it is not reasonably practicable or (B) it is not
reasonably practicable for such company fairly to determine the value of its net assets; or
•
(3) for such other periods as the Commission may by order permit for the protection of security holders of the companyCalculating NAV During An Emergency
SEC Guidance for an Emergency
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SEC 1985 release amending Rule 22c-1 and adopting Rule 22e-2
The fund is expected to make every effort to price investor orders for purchases and redemptions on the day the order is actually received.
If the fund is unable to segregate orders received on the emergency closed day from those received on the next day the fund is open for business, the fund may give all these orders the next price calculated after operations resume.
Emergency closings (e.g., local authorities declare a state of emergency) are to be distinguished from situations where a fund or its transfer agent experience computer failures or other operational problems. Where operational problems unrelated to an
emergency closing result in transactions being processed on an “as of” basis, the adviser, transfer agent or another responsible party maybe liable to the fund for any resulting
© 2016 Vedder Price
“As-of” Pricing
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When the adviser, transfer agent or intermediary fails to properly
process an order as requested, adjustments can be made to correct
these actions commonly called “as-of” transactions
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Orders are reflected on a fund’s accounting records as-of the date on
which the order should have been processed (a date prior to the date
on which the adjustment is actually processed)
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Funds must be reimbursed for any dilution as a result of as-of
transactions
Net Asset Value Calculation Process
1. The NAV of a US mutual fund is due at 5.30 every trading day. The price can be late, but 8.30 is the general final cut-off.
2. Calculating the NAV is a day-long process
a. Cash Availability b. Corporate Actions
c. Portfolio Trading Activity
d. Pay expenses and update Expense Accrual
e. Transfer Agency Activity (purchases and redemptions)
f. Mark to market (calculated on a T+1 basis) based on end of day
g. Submit the new NAV to NASDAQ, Intermediaries, the transfer agency etc.
3. Implication of Automation
Shadow Pricing
1. “The Official Books and Records” can be produced internally or by a service provider. The entity that produces the official NAV has responsibility/liability. 2. Shadow Pricing is any process that checks that process
3. Process can range from minimal to a full re-calculation of NAV and all components 4. Some firms choose to not engage in any shadow pricing
5. Approach may be a risk based analysis designed to find potential errors, not calculate a full NAV
STRIKING THE NAV
Monday: ‘A small problem emerges’
1. Notification of a small problem
a. The problem was not small, but clients were unaware
2. Service Provider informed clients between 3-4 (all times are in EST) that they would not be able to calculate the NAV
a. Is this uncommon?
3. What was the Contingency Plan for most firms?
a. Over time more fund firms have stopped performing shadow accounting b. Liability is a legal issue
c. Does the firm have a process?
4. Delivering the news to Intermediaries
a. Most firms follow the plan and enter a stale price
5. Complicating Factor: Volatile day in the market
DAY 1
Board Crisis Planning
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Who is “in the room”?
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What is the nature of the problem?
(Operational/Legal/Regulatory/Business)
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Who has liability?
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Who is “making the ultimate decisions”
Tuesday: ‘Our plan went out the window at 10am’
1. Awareness of a bigger problem at the service provider, plus… 2. Distributors/Intermediaries step into the situation
a. Intermediaries demand a NAV, even if estimated b. Issue changes from a legal issue to a business issue c. Is there a plan for this situation?
3. What is the New Contingency Plan?
a. The main issue now is the long-term health of the intermediary relationship b. Situation at the fund companies (it depends on the capacity to perform some
level of shadow accounting)
4. This could last several more days… 5. Firms that can use an estimated NAV
6. Complicating Factor: Another Volatile day in the market
DAY 2
Board Crisis Planning
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Who is “in the room”?
•
What is the nature of the problem?
(Operational/Legal/Regulatory/Business)
•
Who has liability?
•
Who is “making the ultimate decisions”
Wednesday: ‘This could last for days’
1. Fund Firms are in full production, or not…
2. Communications with Distributors/Intermediaries
a. Intermediaries continue to demand a NAV or estimated NAV
3. Relationships are built, or destroyed, by actions during a crisis
a. The health of intermediary relationship is the focus b. Talking to all their intermediaries, daily.
4. What are fund companies doing?
a. Different capabilities for shadow accounting b. Estimated NAV or Stale Price from prior Friday
5. News from the service provider…
a. Reality sets in
b. Fund companies are told of the
continuing problems at the service provider
DAY 3
Board Crisis Planning
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Who is “in the room”?
•
What is the nature of the problem?
(Operational/Legal/Regulatory/Business)
•
Who has liability?
•
Who is “making the ultimate decisions”
ETFs: ‘We dodged a bullet.’
1. ETF Sponsors
a. Impacted by system failure, but differently than mutual fund b. ETF’s settle Trade Date +3, instead of T+1
c. Trading on exchange is more important than core NAV production
d. Firms used iNAV (indicative NAV) as the NAV proxy…with subsequent catch-up e. ETF’s came close to breaching T+3 timeline on Wednesday, but didn’t
f. Contingency plans in place
ETF’S
Thursday: ‘The news goes from bad to worse’
Friday: ‘No change’
Monday: ‘Just in time’
1. On Thursday an effort to fix the accounting results in a complete system failure. Rebuilding system starts. Not operational until Saturday.
2. Distributors/Intermediaries are not happy, demand compensation 3. A new crisis
a. Monday is the last day of the Month, meaning there will be a dividend on fixed income funds
4. Recovery by the end of the day Monday 5. Clean-up
6. Liability
a. Transfer agency activity was low (August) b. Shareholder losses only on trade activity
Shareholders keep overpayments Shareholders made whole on
underpayments
c. Estimated NAV’s were closer than expected d. Payments to Intermediaries for reprocessing
DAYS 4, 5 AND 6
Aftermath
1. Rethinking the planned process (far from over)
2. A few of the suggestions from impacted fund companies
a. All fund companies should discuss contingency plans and SLA’s internally and with service provider
b. Firms must address legal issues and how business issues may trump legal issues in certain situations
c. Document plans for a range of possible problems and communication protocol
d. Review of shadow accounting process requires detailed discussions for both internal and external firms. How many functions are enough to make ‘reasonable estimate’.
e. Develop capability to price portfolio on independent system or develop a tailored benchmark for each fund
f. Keep updated lists of NAV distribution lists g. Communication protocol should include:
Internal communications
With the Board or Board Members With other fund companies
With regulators
With investors or brokers/RIA’s (through a flash website) With the press
h. Test the plan on a regular basis
3. What is next?
AFTERMATH
