knowledge 11 September 2019 |

Central Bank Consults on Treatment, Correction and Redress of Errors in Investment Funds

The consultation follows a thematic review of the fund industry’s approach to the treatment of Net Asset Value ("NAV") pricing errors in 2015 following an International Monetary fund ("IMF") recommendation.

The proposed framework will apply to (i) Fund Management Companies (“FMCs”) acting for Irish authorised UCITS and alternative investment funds (“AIFs”) and/or (ii) FMCs authorised in Ireland (which may be acting for non-Irish authorised funds). Depositaries will also be impacted.

Overview of the Proposed Regulatory Framework

The Central Bank is proposing to introduce a new obligation in the Central Bank UCITS Regulations and the Central Bank AIF Rulebook/AIF Regulations, requiring FMCs to ensure that any fund error that occurs is “Appropriately Rectified”, which will entail the:

• identification and classification of the error;
• 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.

Depositaries will also need to ensure that an error has been Appropriately Rectified.

The proposed framework will comprise three distinct components, namely:

• Treatment – how errors should be treated when they arise, including when such errors should be considered material;
• Correction – 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.

Under the proposed framework, the steps that an FMC will be required to take to ensure that an error is Appropriately Rectified differ depending on the type of error that has occurred and, in this regard, the proposed framework distinguishes between:

• A NAV Error - an error in the calculation of the NAV;
• An Investment Breach Error – an error relating to the investments of a fund and non-compliance with the applicable investment restrictions;
• A Fee Error – an error related to the overpayment of a fee; and
• A Control Breach Error – an error which does not fall into the above three categories (such as making a redemption payment to the wrong investment account where this is subsequently returned in a short timeframe).

Treatment of Errors

Once an error is identified, an FMC and depositary will be required to assess the materiality of the error as this will affect its treatment in terms of reporting, notification and redress. The FMC will be required to consider both Quantitative and Qualitative Materiality Thresholds when assessing whether an error is material.

The proposed Quantitative Materiality Thresholds are:

• Money Market Funds ("MMFs") – 0.10% of NAV; and
• other Investment Funds – 0.5% of NAV.

An error that does not meet the proposed Quantitative Materiality Thresholds may still be qualitatively important. The Central Bank is proposing that the factors to be taken into account in considering whether an error meets the Qualitative Materiality Thresholds should include the following:

• an error may be below the materiality threshold at an individual valuation point but exceed the threshold materially on an aggregate basis. In determining if an error is material, the cumulative impact should be taken into account;
• the specific circumstances in which an error took place may have a significant bearing as to whether it merits being re-classified as material. Examples of such errors could include:
  • a subscription or redemption is not processed appropriately and this results in the transaction being allocated to the incorrect investor or a transaction being processed for an incorrect time period;
  • any error or series of errors which results in a concern about the overall control environment in which the investment fund is managed;
  • an error or a type of error which has recurred on a number of occasions; and
  • an error which, all things being equal, was likely to occur given the particular actions of the FMC.

Reporting / Notification

Both FMCs and depositaries are subject to reporting obligations under existing legislation. The Central Bank is proposing to maintain dual reporting obligations but to amend obligations imposed on FMCs to consist of either imposing an obligation on an FMC to report:

• errors to the depositary, which in turn would fulfil the regulatory reporting obligation as required – generally a depositary is required to report any material breach of investment fund legislation and regulatory requirements under the Central Bank UCITS Regulations and the AIF Rulebook; or
• material errors which have not been reported by the depositary to the Central Bank.

The FMC and depositary will also be required to maintain a written record of all errors that occur.

Regarding notification of errors to investors, the Central Bank is considering introducing an obligation on FMCs to notify investors of any error found to be material, irrespective of whether redress is required or not. It is also soliciting feedback on whether there is merit in requiring that investors be notified at times when redress is required, including in cases where redress is required but not paid as it falls below the De Minimis Limit (see below).

 Redress

The Central Bank is proposing to introduce guidelines and rules in relation to how redress arrangements should operate where errors occur, including principles prescribing how such redress arrangements should generally operate. In this regard, the Central Bank is seeking feedback on a number of questions, including on whether De Minimis Limits should apply to redress payments and, if so, what these limits should be.

In the consultation, the Central Bank also lists a number of elements that it considers should be provided for in the regulatory framework regarding how redress should be operated, as follows:

• when calculating the Payment of Redress, an FMC must act promptly in determining the financial impact of an error, in particular distinguishing between the different categories of investors who are affected. It is intended that Central Bank guidance will provide additional details with respect to the appropriate approaches to apply where redress is required;
• the FMC must act as quickly as possible to correct an error and quantify the impact for the fund/investors;
• the Payment of Redress should be fair, clear, provided in a timely manner and easily accessible;
• the FMC must identify all potentially impacted investors and communicate with them in a clear and timely manner;
• an investment fund should not be subjected to any administrative or other costs incurred from the investigation or from the Payment of Redress;
• the process leading to the Payment of Redress should not impose unreasonable demands or burdens on impacted investors;
• the Payment of Redress to a fund and / or investors should be made in a timely manner without prejudice to the rights of the affected funds and/or shareholders;
• in the case of NAV Errors or Control Breach Errors deemed to be material, the Payment of Redress should be made in all circumstances;
• in the case of Investment Breach Errors, the Payment of Redress should be made in all circumstances where the error is as a result of an advertent breach;
• in the case of an inadvertent Investment Breach Error, the Payment of Redress will generally not be payable unless otherwise determined by the depositary;
• in the case of Fee Errors, the Payment of Redress must be made in all circumstances;
• errors may arise from the actions of delegates. While an FMC may seek to arrange for payments from a delegate, the FMC is responsible for ensuring that errors are Appropriately Rectified in a timely manner and the depositary is responsible for ensuring that this is the case; and
• an FMC or a delegate/other third party should not gain as a result of an error. Any such gain should be attributed to the relevant fund.

Next Steps

The Consultation Paper is part of a two part process in relation to a regulatory framework for the treatment, correction and redress of errors in investment funds. Following the closing of the consultation period, on 9 December 2019, the Central Bank will consider responses received in order to prepare related requirements and guidance, which will be subject to further consultation as appropriate.