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How to Recognise and Treat Active Non-Compliance with Investment Guidelines in Funds – for Custodian

Custodian banks are controlling the lawful fund administration and are, pursuant to the custodian bank circular, also facing the daily task of differentiating between active and passive non-compliance with investment guideline, seeking verification from the fund manager and commenting and deriving actions for the fund manager where applicable.

Some common questions about monitoring:

What is active and passive non-compliance? How to differentiate between the two forms of non-compliance in view of given data? What actions are required? 1. Active vs. passive non-compliance with investment guidelines.

In case of an active non-compliance, the fund manager performs an activity leading to a change in the non-complying asset. In case of a passive non-compliance, this is not the case and the change in assets is technical (split, reverse split, etc.). This also applies to rating changes without order activities. Passive non-compliance is often caused by valuation changes.

It needs to be noted that this definition has its limits and specific cases may need to be treated on a case-by-case basis. These include options, mergers, bonus shares, a combination of causes and further possible scenarios. Splitting hairs is not recommended here as, theoretically, there are unlimited possibilities (e.g. contractual rules with benchmark duration requirements and their announced change in combination with illiquid assets and a tight market).

It is interesting to note that the adjectives “active” and “passive”, in the context of non-compliance with guidelines, can only be seen in the custodian bank circular, but not in InvPrüfBV (Investment Examination Report Regulation), InVVerOV (Regulation on the Rules of Conduct and Organisational Rules Pursuant to the Investment Code) or InvG (Investment Act).

InvPrüfBV prefers the terms “intentional infringement” and “unintentional infringement”. An intentional infringement is synonymous with an active non-compliance.

In case that custodian banks cannot or will not make a sufficiently accurate decision, all instances of non-compliance can immediately be reported to the respective asset management company, assuming an active non-compliance. This may lead to slightly higher costs, but is more secure as passive non-compliance can be transferred more timely (e.g. via downgrades).

In the event that actions are required, a quicker analysis can be achieved together or by the administrators. Examples include valuation, exclusions and synchronisation or the date of processing corporate actions.

  1. How can custodian banks detect these instances of non-compliance?

Based on order activity differentiation, there are theoretically two possibilities: The first possibility is to compare two dates of supply at the dates t-n and t. Technical changes have to be eliminated as irrelevant in this case.

The second possibility is to access all transactions (orders) processed between t-n and t.

Either approach has the disadvantage that cases that cannot be guaranteed automatically have to be verified manually using the data. This audit and all automatic audits need to be implemented in line with the internal requirements imposed by the internal and external auditors and the respective members of the executive board. Subscription rights that are logged in and that lead to non-compliance can be viewed as active or passive depending on the asset management company and the custodian bank. This is the case, for example, when there is no trade in subscription rights. The higher the number of cases that can be anticipated in a standard approach description, the higher the security during the processes.

  1. What actions are required?

The custodian bank in its controlling function has been provided by the legislature with a time frame to communicate non-compliance after detection. Active non-compliance needs to be communicated immediately, passive non-compliance within 5 days after commencement. In addition to the timely requirements, the content should be communicated as follows:

Is it really a case of non-compliance? The cause may also be found in wrong, out-dated, not synchronised or otherwise defined data or the structure of the rules. A special report is required in case of a relevant data error or an aberrant test logic, especially in model 1 processes.

How to remedy the non-compliance? Suggestions have to be prepared together with the fund manager and further steps need to be decided upon or acknowledged. These steps need to be temporary and their duration needs to be controlled by a buffer to comply with statutory regulations.

In the event of a passive non-compliance, the 5 day period mentioned in the custodian bank circular corresponds to the 10 day period in the InvPrüfBV, because a report only needs to be made 10 days later (if the non-compliance is >= 0.5% of NAV); in reality, fund managers generally want to avoid this report. The immediate report of active non-compliance is also fine, because the asset management company has to report non-compliance that last more than 3 days and are of a certain value (see above).

Problems arise only when the custodian bank does not monitor daily. Assuming that special funds are monitored only once per week every Friday, active non-compliance occurring early in the week cannot be remedied without reporting pursuant to InvPrüfBV (unless already detected by the asset management company). This technical constellation, however, is explicitly mentioned and approved by the supervisory authority in the custodian bank circular.

In addition to these 3 points, it needs to be discussed how model 1 and model 2 are different in terms of active and passive non-compliance. In model 1, this is provided by the same specific requirements to rely more heavily on data and regulations, to inspect them regularly and to question the interpretation of the contractual basis. The requirements made in the custodian bank circular need to be met as a minimum. The different amounts of regulatory and contractual requirements are often underestimated. Excerpts of regulations for fund types are always the same and are often attached in bulk. Contractual rules tend to be more customised and to follow a scheme only partly. Due to the increased amount of contractual rules, they cause more problems.

Model 2 differentiates automatically through independent monitoring and comparison of the results, because in the presence of deviations that are not caused by data, the validation rule of the custodian bank or the asset management company has to differ with regards to the content. In case of sharp deviations, data needs to be monitored.

If certain aspects cannot be monitored automatically, manual monitoring needs to be developed by the custodian bank who still has to pass on its findings as active ore passive.


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