Paperjam: The Financial Sector Supervisory Commission (CSSF) on 29 March 2024 published the circular 24/856 on “protection of investors in case of an NAV calculation error, an instance of non-compliance with the investment rules and other errors at UCI level.” This first question might seem a bit simple, but could you explain exactly how NAV calculation works, how a NAV calculation error is defined and why it could have an impact on investor protection?

NAV (net asset value) calculation has an immediate impact on investors as it involves determining the value of a fund’s assets minus its liabilities, divided by the number of shares. This figure is critical, as it directly influences the share price that investors use for subscribing and redeeming in a fund.

The new circular 24/856 specifies that a NAV error occurs when the result of the NAV calculation is incorrect, due to one or several factors amongst other: human error, issue with internal controls, failure in IT accounting, or communication systems and processes. In addition, investment breaches, which are cases of non-compliance with regard to a fund’s investment limit, are also considered as errors.

These errors cause failure to comply with the accounting and valuation rules established by law and/or the fund’s prospectus.

To ensure that investors can enter and exit the fund daily, the NAV calculation must be conducted in a professional and fair manner for all investors. If an error occurs, a procedure for NAV errors (section 4) must exist to correct the error, which may imply the compensation of affected investors including the funds, depending on the materiality criteria. It is important to note that the ultimate responsibility for errors, according to the new circular, lies with the management entities (including boards of directors).

What are some other possible errors that may occur? How can these calculation errors be avoided or addressed?

In addition to NAV errors, there are the four types of errors specified in the section 6 of the circular, regardless of materiality, which are applicable to open-ended and closed-ended funds: incorrect application of swing pricing, payment of undue fees at the UCI level, incorrect application of cut-off rules, and wrong allocation of investments at the UCI, sub-fund, or share class level.

To prevent these NAV computation errors, a robust operational control framework, as well as strong data and modern IT infrastructure, have to be in place.

It is also our understanding that this circular is a call for the actors to adopt advanced technology platforms. BNP Paribas’ Securities Services business invested, as fund administrator in 2022/23, in a new system of workflow and execution management (WEM\Temenos) to enhance its global NAV accounting and control framework, and implemented in parallel, as fund depositary, an independent NAV review process leveraging on a Next Gate Tech tool. It goes without saying that both fintechs are Luxembourg-based. Finally, let’s not forget our human expertise and competencies in both domains--fund administration and depositary bank--which are a key success factor to anticipate and avoid NAV errors and underlying investor impacts on the fund administrator side as well as to ensure funds are properly managed on the depositary side.

Circular 24/856 repealed circular 02/77 on the protection of investors in case of NAV calculation error, which was published in November 2002. Can you tell me what the main elements of this initial circular were?

One of the key elements of circular 02/77 was its significant contribution to setting the quality standard for the Luxembourg fund industry. It established a high level of rigour, ensuring that Ucits funds and actors supervised by the CSSF adhered to the highest standards of NAV calculation and compliance with investment rules. This level of precision and commitment was crucial in making Luxembourg one of the largest fund administration hubs globally, as it reinforced confidence in the market for fund promoters and investors worldwide. Additionally, the circular emphasised the importance of investor protection with the indemnification of affected investors in case of error.

We consider this has been a key factor in building Luxembourg’s reputation as a trustworthy and reliable financial centre for investment funds.

The rules in circular 02/77 was therefore used for a little over 20 years. Is this “lifetime” common? How long do CSSF circulars usually last?

Circular lifetimes can vary, and in the case of circular 02/77, its 20-year duration is quite remarkable. This circular is uniquely Luxembourgish, as it wasn’t based on any specific EU legislation. It was created as a way to distinguish Luxembourg and raise the quality standards for the fund industry.

The fact that it lasted for such a long period and is only now being updated reflects Luxembourg’s commitment to continuously improving these standards in line with recent market developments, such as the growth of Sifs and Eltifs, and the significant expansion of the alternative investment space.

Finally, the circular’s evolution shows the regulator’s willingness to widely share applicable principles by regrouping the main aspects in one single document, which in addition formally clarifies the range of funds in scope. The update is renewing Luxembourg’s quality standards, in continuity with the long-standing quality demand on the marketplace.

Why was it time to update the circular?

The financial landscape has changed significantly since 2002--mancos did not exist in 2002, nor products like Sif--and saw the rise of alternative investment funds, the increasing use of complex investment strategies and techniques and growing expectations of investors around transparency. These developments,  new fund vehicles and actors, along with the regulatory changes at the European level, such as Ucits V and AIFMD, have prompted the need for a more comprehensive framework, addressing modern risks and ensuring greater investor protection. Circular 24/856 is designed to be more adaptable to the contemporary fund industry.

Included in the scope are European long-term investment funds (Eltifs), which have leapt into the spotlight these past few years. Is the updated circular partly in response to the rise of the Eltif and other alternative funds?

The first circular greatly contributed to the success of Ucits by enhancing the quality and setting high standards, which helped build Luxembourg’s strong reputation worldwide. The updated circular extends these high standards to alternative funds supervised by the CSSF, including Eltifs.

It shows that Luxembourg is adapting its regulatory framework and standard of quality to accommodate newer fund types that have become increasingly important in Luxembourg.

Circular 02/77 came to 12 pages; circular 24/856 is nearly four times as long and counts 47 pages. What would you say are the main changes in the new and revamped circular? How are these meant to protect investors?

Circular CSSF 02/77 was concise in its description of errors, and several market practices had developed and were adopted by the participants. The new circular is significantly more comprehensive than the initial one and provides clear guidelines for correcting NAVs (errors or investment breaches), minimising disruption, compensating investors and protecting their interests. There is a strong emphasis on roles and responsibilities, internal control mechanisms, periodic reviews of valuation processes and enhanced reporting obligations to the CSSF in case of material error.

This increase reflects the significant evolution of market practices and requirements. Bringing all these elements together in a single document demonstrates the maturity of Luxembourg’s financial sector. For foreign players entering the market, it adds a layer of certainty and clarity.

In addition, the new circular is applicable to a wider range of funds, including alternative funds. And last but not least, it places a clear focus on the responsibilities of all stakeholders, starting with the board, management company and delegates. This underlines the importance of clearly documenting the roles and responsibilities of all involved parties in delegated relationships, ensuring proper oversight.

We view this as an important step forward, aiming to ensure a consistent and clear approach on supervised funds, that errors are detected early, corrected efficiently, and that investor compensation processes are more transparent and standardised.

How do you anticipate the new circular to impact private market fund firms and the Luxembourg marketplace?

In the private equity space, we can still see more diversity in operational models compared to Ucits, and this circular aims to bring greater clarity and standardisation.

In section 6, the rules around the management of fees now also apply to these types of funds, ensuring consistency across the board. The most significant impact, however, is in section 3, which addresses the roles and responsibilities of key stakeholders.

Ultimately, the circular can also strengthen Luxembourg’s reputation as a leading hub for sustainable and well-regulated fund management, which is crucial for maintaining its competitive edge in the global market.

The new rules will come into force starting 1 January 2025. What is important to keep in mind as we approach this date?

Fund administrators need to ensure that their internal systems, processes and governance frameworks are fully aligned with the upcoming requirements before the implementation date. This may involve updating NAV calculation procedures, enhancing internal controls and providing extensive training to staff on the new rules.

Boards and management companies must ensure a collaboration amongst experts, advisors (legal and audit) and delegates to ensure a seamless transition.

More generally, it’s crucial to identify areas that need adjustments (including in contractual documentation or oversight) to prevent any last-minute rush to meet the requirements. Every entity must evaluate its preparedness in implementing the new circular to ensure they are ready by the deadline.

Anything else important to know about circular 24/856?

The increased focus on fund protection, NAV calculation processes and error handling ensures the long-term protection of investors and reinforces the integrity and attractivity of the Luxembourg market.

This circular updates Luxembourg’s regulatory framework and indirectly reflects a growing emphasis on responsible asset management. Given the significance of the changes, it’s crucial to ensure that all stakeholders are aligned on key items like materiality thresholds and procedure for NAV errors.

It’s more than ever important to be supported by key stakeholders that are able to follow current regular evolutions, invest in robust and new technology as well as having the adequate business experts servicing you.

This article first appeared in the October 2024 supplement of Paperjam magazine. The Alfi private assets conference on 25 September features a panel discussion on the CSSF circular 24/856.