As a senior legal advisor at the Luxembourg office of the global law firm Norton Rose Fulbright, Cyril Clugnac offers an in-depth analysis of the latest changes to the grand duchy’s regulatory landscape in an interview with Paperjam. He explains how the updated Luxembourg Financial Sector Supervisory Commission (CSSF) Circular 24/856, which replaces Circular 02/77, addresses the risks associated with net asset value (Nav) calculation errors and enhances investor protection in collective investment undertakings.
Kangkan Halder: Could you provide a brief overview of CSSF Circular 02/77 regarding the protection of investors in the event of Nav calculation errors?
Cyril Clugnac: The CSSF Circular 02/77 on the protection of investors in the event of Nav calculation errors and the correction of the consequences resulting from breaches of the investment rules applicable to undertakings for collective investment (UCIs) supervised by the CSSF sets out the minimum rules of conduct to be followed by those responsible for a UCI’s management and operations.
In practice, it targets errors resulting from the incorrect calculation of the Nav of a UCI or from non-compliance with the investment rules applying to a UCI, such as its investment policy and borrowing limits. Circular 02/77 sets the criteria, such as detection thresholds in the case of Nav calculation errors, for the materiality of such errors and the trigger for the necessary corrective and compensatory actions to be taken. The aim is to safeguard the interests of UCIs and their investors, as well as increase investors’ trust in these UCIs and their management.
Historically, Circular 02/77 has been supplemented by guidance provided by the CSSF in various formats, such as FAQs and annual reports. This guidance has been influenced by regulatory changes in the supervision of UCIs and shifts in industry practice that have occurred since the circular was issued.
The new CSSF Circular 24/856, which repeals Circular 02/77, consolidates that guidance into a single document while, among other things, expanding the scope of the previous circular by covering new types of UCIs and addressing new types of errors, such as errors regarding the payment of costs/fees and swing pricing.
CSSF’s Circular 24/856 sets a high bar for the industry, by, among other things, approaching compliance and investor protection
Why is the new circular significant for both investors and UCIs?
The Circular 24/856 updates the framework established 22 years ago by Circular 02/77. The industry has evolved in different directions during this period. Since 2002, when Circular 02/77 was published, many significant milestones have changed the landscape of UCIs. These milestones include the implementation of Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities, implementation of Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on alternative investment fund managers (AIFMs), and the emergence of new products such as specialised investment funds (SIFs), European long term investment funds (Eltifs), European venture capital funds (EuVECA), the European social entrepreneurship fund (EuSEF) and money market funds (MMFs).
These new products, and the evolution of the related industry in Luxembourg, came with a growing investor base, so increasing investors’ exposure to the risk and consequences of Nav calculation errors and non-compliance with the relevant investment rules by UCIs. This was something the CSSF was very aware of, resulting in it updating the Circular 02/77 framework through active communication with the industry, conducting inspections and issuing fines. But one should not forget the key aim of the framework set by Circular 02/77, which was to ensure that investors have confidence in UCIs, something controls, sanctions and a fragmented framework do not foster.
So, it was time to consolidate and clarify the rules and bring more into their scope to reflect the reality of the industry. As a result, CSSF’s Circular 24/856 sets a high bar for the industry, by, among other things, approaching compliance and investor protection as a collaborative and proactive exercise which concerns all those involved with a particular UCI. It reinforces the methodologies for correction, prevention and rectification of Nav calculation errors, for non-compliance with the investment rules and for other errors (including tolerance thresholds), and it addresses a broader spectrum of operational risks.
When it comes to Nav calculation errors, Circular 24/856 distinguishes between open-ended and closed ended UCIs
This circular is also key for investors in UCIs as it provides explicit guidelines for compensation and cost bearing in relation to Nav calculation errors, non-compliance with the investment rules and for other errors, including incorrect fee payments and investment allocation errors. For UCIs, this new circular will certainly require them to update their Nav calculation procedures, enhance their internal controls and ensure that proper internal training on these new rules is provided.
It is also important to note that, when it comes to Nav calculation errors, Circular 24/856 distinguishes between open-ended and closed ended UCIs, taking into account the fact that such errors have more significance for opened-ended UCIs which normally calculate their Nav on a daily basis, allowing investors to enter or exit each day. CSSF Circular 24/856 does not require closed-ended UCIs to notify Nav calculation errors to the CSSF, as they are exempt though certain of the guidelines set out in chapter four of Circular 24/856. However, other types of error, for example, incorrect fee payments, must be reported to the CSSF by closed-ended UCIs, and all errors, even if not reportable to the CSSF, must be corrected.
Can you share a recent example where a Nav calculation error had severe consequences?
I do not have a particular example in mind, but simple recording errors can lead to severe consequences, such as recording a financial instrument in the wrong currency or over-valuating an asset. In opened-ended funds, where redemptions are allowed on a regular basis based on Nav, these types of errors can lead to substantial payment errors with a snowball effect, including having to reprocess redemptions or claw back amounts one way or the other consequently.
However, in Europe in particular, the reputational damage of such errors can often cause more harm than the financial consequences, given that the fund’s managers are ultimately responsible for the Nav calculation.
In your opinion, what are the main causes of Nav errors, and what measures can be implemented to ensure better compliance?
Turnover and complexity are factors contributing to Nav calculation errors in recent years, coupled with a more volatile market. It is no surprise that volatility leads to more material consequences when these errors are made. Better compliance will come from better control of the Nav production process, requiring cooperation and proactiveness from all actors involved in this process, so as to ensure in particular an accurate flow of information between them. This can only be achieved if clear and rigorous procedures are put in place.
In its 2023 annual report, the CSSF noted 344 declarations of Nav errors. While this figure is slightly lower than the 462 declarations in 2022, do you consider this number excessive?
I do not necessarily consider this number excessive, particularly given the turmoil that has agitated the economy and the market in recent years as a direct consequence of the different global events we have experienced. Such an environment is prone to lead to Nav calculation errors.
The CSSF approved a total compensation amount of €49.6m to investors for Nav calculation errors in 2023, which is more than double the €21.2m in 2022. What factors do you believe contributed to this increase in compensation, and how might this reflect the CSSF’s evolving approach to investor protection?
This increase in compensation may have been due to two key factors, namely the increased materiality of the Nav calculation errors and the shortcomings observed by the CSSF during its checks on the 2022 financial year.
As we approach the fourth quarter of 2024, what are your overall expectations regarding the number of Nav errors and potential compensations for investors?
The increased oversight of Nav calculation errors, the change in rules and increased scrutiny by the regulators, coupled with an ongoing agitated economic environment, may lead to such errors being detected and reported more frequently, with high levels of compensation being paid to investors when these errors are material, in the spirit of ensuring investors receive due compensation and protection.