Crisis Planning: A Case Study

Transcription

1 Crisis Planning: A Case Study Mutual Fund Directors Forum Webinar Series February 18, 2016 Barrington Partners Hubbard Garber, Managing Director Judith Benson, Partner Vedder Price Bruce A. Rosenblum, Shareholder v.2

2 THE BACKDROP 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 Barrington Partners 2

3 What Is NAV? Net Asset Value (NAV) is the value of a fund s assets minus its liabilities, divided by the number of fund shares outstanding 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 3

4 When Is NAV Calculated? 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) 4

5 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 5

6 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 and is disseminated to the public every 15 seconds 6

7 Calculating NAV During An Emergency 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 by the 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 company 7

8 SEC Guidance for an Emergency 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 dilution. 8

9 As-of Pricing 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 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) Funds must be reimbursed for any dilution as a result of as-of transactions 9

10 STRIKING THE NAV 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 2016 Barrington Partners 10

11 DAY 1 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 2016 Barrington Partners 11

12 Board Crisis Planning 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 What other parties who should be notified? 12

13 DAY 2 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 2016 Barrington Partners 13

14 Board Crisis Planning 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 What other parties who should be notified? 14

15 DAY 3 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 2016 Barrington Partners 15

16 Board Crisis Planning 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 What other parties who should be notified? 16

17 ETF S 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 2016 Barrington Partners 17

18 DAYS 4, 5 AND 6 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 2016 Barrington Partners 18

19 AFTERMATH 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? 2016 Barrington Partners 19