Central Bank Publishes Consultation Paper on Errors in Investment Funds

Executive Summary

What has been issued?

A consultation on new rules and guidance for dealing with errors in investment funds, including NAV errors, investment breaches, fee errors and control breaches.

Will the proposals materially alter the status quo?

Yes. If the proposals are followed there will be increased responsibility, and potentially liability, for boards falling within scope. The proposals also introduce new requirements for the assessment and appropriate rectification of errors.

Who is directly affected?

Fund management companies appointed to Irish authorised UCITS and AIFs and Irish fund management companies appointed to non-Irish authorised funds. Depositaries will also have a key role.

Covered funds?

Irish UCITS and AIFs but also non-Irish authorised funds managed from Ireland.

Should other parties be interested?

Yes. The majority of services providers to funds falling within scope will be indirectly subject to the new responsibilities, rules and guidance. Investors will also be interested as to whether CP130 will provide them with additional protection in a proportionate manner.

Timeline?

The deadline for responses to CP130 is 9 December 2019.

Maples Group view?

We welcome the proposal to enhance investor protection and to issue clear rules and guidance. However, some proposals may be considered to impose disproportionate responsibility on boards. There is also a risk of material divergence from Irish Funds’ guidance which has been widely followed to date. Detailed analysis is set out further below.

Current Irish Rules and Background

Guidance Paper 6 Investment Restriction Breaches, Pricing Errors, Compensation & Reporting issued by Irish Funds¹  is currently widely adopted and applied by industry.

However, Guidance Paper 6 (“GP6”) has not been sanctioned or approved by the CBI. In 2015, the CBI carried out a thematic review of the industry approach to the treatment of Net Asset Value (“NAV”) pricing errors. This review covered GP6 and also stemmed from an IMF² recommendation to the CBI to publish rules covering fund errors.

The proposal in CP130 stems largely from this body of work and also supervisory experience of the CBI, IOSCO principles and engagement with industry stakeholders.

Appropriate Rectification

The CBI states the guiding principle for the framework should be that where an error occurs, the fund / or the investor must be “appropriately rectified”.

This concept is to be broadly applied to include reporting of errors, notification to investors and redress. To be effective, the new standards will require that the fund / investor is restored to the position that it / they would have been in had the relevant issue not arisen.

Scope

The CBI considers that a fund management company is ultimately responsible for ensuring that the error is appropriately rectified and the depositary has a role in ensuring that this is the case.

The term “fund management company” includes:

• a UCITS management company;
• an authorised AIFM;
• a self-managed UCITS investment company; and
• an internally managed AIF.

Where a fund management company manages non-Irish authorised funds (e.g. a Luxembourg SICAV), the new framework will apply without prejudice to local rules and guidance in this area. CP130 sets out the responsibilities and reporting obligations that should apply to fund management companies and to depositaries with respect to errors.

Key Components

CP130 comprises three distinct components:

• Treatment – how errors should be treated when they arise, including when such errors should be considered material;
• Compliance – how errors should be corrected, including what reporting and notification obligations should apply; and
• Redress – how the fund and / or investors should be appropriately rectified following an error.

Error Types

Four errors types are identified:

• NAV Error – an error in the calculation on NAV;
• Investment Breach Error – an error relating to the investments of a fund and non-compliance with the applicable investment restrictions;
• Fee Error – an error related to the overpayment of a fee; and
• Control Breach Errors – errors which do not fall into the categories above.

The proposed framework differentiates on how an error should be “appropriately rectified” depending on the type of error concerned.

Responsible Parties and Their Obligations

In the event of an error, it is proposed that the fund management company should ensure that the error is appropriately rectified, taking into account CBI guidance. Appropriately rectified will entail:

• identification and classification of the error (including assessing materiality);
• correction of the error (including compliance with any reporting and notification obligations); and
• redress of the error (including the payment of redress to the fund and / or investors).

It is intended that this obligation will be explicitly set out in future iterations of the Central Bank UCITS Regulations and the Central Bank AIF Rulebook / AIF Regulations.

In the case of depositaries, it is proposed that, in the event of an error, the depositary must ensure that the error has been appropriately rectified by the fund management company.

Treatment of Errors

Once identified, an error must be corrected without delay. The fund management company and the depositary should assess the materiality of the error as this will affect the treatment of that error in terms of reporting, notification and redress.

Quantitative and Qualitative Factors

Both quantitative materiality thresholds and qualitative materiality factors should be considered by the fund management company / depositary to assess materiality.

From a quantitative perspective, it is proposed that any error resulting in an impact the same or greater than:

• 0.10% of NAV for a money market fund; or
• 0.50% of NAV for other investor funds should be considered material.

The CBI proposes a qualitative overlay, so that even if an error is deemed not to meet the quantitative threshold, it should be assessed in the context of qualitative factors. Examples of these factors are set out in CP130, including inadequate controls.

Finally, the CBI is examining the inter-play of these rules with existing laws and regulations. For example, Regulation 77 of the UCITS Regulations 2011 contains provisions to assess inadvertent breaches. It has invited industry to confirm whether the concepts of advertent and inadvertent breaches are well understood noting the overlapping and sometimes conflicting rules and guidance.

Reporting to CBI and Notification to Investors

The dual reporting obligations of the fund management company and depositary will be retained under the proposed framework however it is proposed that reporting should be with respect to material errors only.

Observing that many fund management companies rely on the depositary to meet their reporting obligations to the CBI in respect of individual funds, the CBI proposes imposing an obligation on a fund management company to:

• report errors to the depositary, which in turn would fulfil the regulatory reporting obligation as required; or
• report any material errors which have not been reported by the depositary to the CBI.

It is proposed that both the fund management company and depositary should be required to maintain a written record of all errors that occur.

On notifications to investors, the CBI proposes that fund management companies notify investors of any error found to be material irrespective of whether redress is required or not. This goes further than current industry practice whereby investors are notified when two conditions are met: (i) the error is above the materiality threshold and (ii) the investors are directly affected by the error and are due to be paid redress.

Redress

Payment of redress is considered as a payment to return the affected fund / investor to the position that it / they would have been in had an error not arisen. CP130 proposes that the fund management company should be required to ensure the payment of redress to the affected fund and / or investor, taking into account CBI guidance on how to determine whether the error is material or non-material.

While errors may arise from the actions of delegates, responsibility ultimately lies with the fund management company to ensure that errors are appropriately rectified and with the depositary to ensure that this is the case.

Current industry practice provides for “de minimis limits” meaning thresholds below which redress will not be paid. While not without merit, the CBI considers that current limits (€50 for retail investors and €500 for institutional investors) appear excessive and is seeking feedback with a view to agreeing new limits.

For material errors CP130 provides that redress should be made in all circumstances. However, the CBI acknowledges that each type of error will have different remediation requirements and the materiality threshold may not be appropriate in all circumstances.

Payment of redress on foot of an error shall be made without prejudice to the rights of the affected fund and / or investors.

The CBI also sets out specific elements which it considers should be in a redress regulatory framework.

Consultation Period and Process

CP130 is part one of a two part process. Stakeholders are requested to provide responses to the questions and give any general observations on the matters discussed or issues raised. The closing date for submissions is 9 December 2019.

Responses received will inform related requirements and guidance, which will, in turn, be subject to further consultation as appropriate.

How can Maples Group help?

We will be contributing to industry and individual responses in addition to our own.

We will also be working with our clients and their international advisers, where the proposals have particular relevance, e.g. where a fund has previously considered these errors under Irish Funds’ guidance. Our teams have significant experience in advising on current rules, reviewing contractual terms to ensure redress provisions are effective and advising in circumstances where errors or responsibility is disputed.

Further Information

Should you have any queries or comments, please share them with your usual Maples Group contact or any of the contacts listed below.

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¹ Irish Funds is the representative body for the funds industry in Ireland

² International Monetary Fund