Software glitch putting custody arrangements in spotlight

Software problems late last month at Bank of New York Mellon Corp. affecting the valuation of 1,200 mutual funds and exchange-traded funds have been resolved, but the issue is leading asset owners to take another look at their custodians.

The Aug. 24 malfunction of the InvestOne valuation program from SunGard Financial Systems, Wayne, Pa., and the subsequent failure of a backup system, left New York-based BNY Mellon unable to provide actual net asset values for mutual funds and exchange-traded funds from 66 fund companies, including Federated Investors, Goldman Sachs Asset Management, Invesco PowerShares, Guggenheim Partners and Prudential Investment Management, sources said.

SunGard officials took responsibility for the software issue, which was resolved by Aug. 31, according to statements from both companies on their respective websites.

Retirement funds contacted by Pensions & Investments were not immediately affected by the malfunction, but sources said it was yet another reason all asset owners should take a closer look at their custodial arrangements.

“At the end of the day, valuation and pricing of the funds is (custodians') responsibility and is what they are paid to do,” said Edwina Easton, Chicago-based director-North America at Amaces, a custodial consultant to institutional investors.

“Ensuring proper technology implementation, backup and mirroring of systems is critical. For an institutional client or participant to understand the extent of the impact to their current assets and accounts, they will need to understand from their investment manager and BNY Mellon whether their plan or funds were affected. However, this goes further than simply understanding the "now' impact. An institutional client should understand how they are set up inside of the custodian's systems.”

Among corporate 401(k) plans that use BNY Mellon as custodian are the $39.88 billion plan at AT&T Corp., Dallas, and the $16.5 billion plan at Hewlett-Packard Co., Palo Alto, Calif. Hewlett-Packard was not affected by the BNY Mellon software issue, according to a company spokeswoman. An AT&T spokeswoman said plan officials would not comment.

The Florida State Board of Administration, which oversees the state's $8.8 billion 401(a) plan as part of the $181.3 billion in assets the board manages, had seen “no impact on our operations in regards to the valuation problem” and there was no concern that the computer issue at BNY Mellon, the board's custodian, would affect the FSBA, said Dennis MacKee, spokesman.

Sources said one issue that needs to be resolved is who would make whole any funds that lost assets — BNY Mellon, SunGard or the individual fund managers —as a result of the software issue.

BNY Mellon would not comment on that issue; Kevin Heine, company spokesman, said only that the custodian has been concentrating on “meeting our clients' fund accounting needs and restoring the SunGard platform,” but he added that BNY Mellon would “continue to communicate with all of our clients to address any questions or concerns they may have.”

SunGard has been “focused on getting our client BNY Mellon back up and running,” said Michael Gormley, spokesman. The question of asset restoration “has not been a focus at all to this point.”

Keith Overly, executive director of the Ohio Public Employees' Deferred Compensation Plan, Columbus, said while none of the affected funds are options in the $11.2 billion 457 plan, the plan faced a similar NAV issue with some of its options several years ago. The plan handles record keeping in-house.

He said the biggest issue is reconciling the affected funds when participants make withdrawals before their NAVs are corrected.

“If the assets are withdrawn, for example, would we get money back from the fund manager or would it just cost us?” Mr. Overly said. “A lot depends on what happens in the market during that time. In the case of a participant withdrawal, we looked at a de minimis cutoff, say anything below a certain amount we would take the loss, or if above a certain amount we would make a further distribution to the participant.”

After the software malfunction, teams from BNY Mellon and SunGard set to work, with the help of information from the affected funds' money managers, to establish fair value NAVs for the funds in a move that was “masterful,” said Greg Korte, principal and practice leader, trust, custody and securities lending for North America, at Mercer Sentinel, Chicago, a consultant on asset servicing and investment operations.

“The unique piece in all this that kept (BNY Mellon) from total destruction was to use information from their manager clients and from futures to adjust the price to what they believe would happen. They used a synthetic fair-value price since they couldn't get the real NAV done through their systems. By using the fair-value NAV until the real valuations were ready, trading wasn't affected.

“Under a pressure-packed situation, that was quite a feat,” Mr. Korte said. “Ultimately, their safeguards really saved the day.”

However, Amaces' Ms. Easton said the fixes do not guarantee that the NAV price on those funds is accurate. She said that, depending on the individual fund or a DC participant's option, the materiality threshold — the difference between the fair value NAV calculation and the recalculated NAV — could be greater than the 10- to 50-basis-point standard established by market practice.

“If the NAV is off by more than the stated materiality, reprocessing of the NAV will need to happen. If the reprocessing needs to take place, then multiple other downstream parties (transfer agents, record keepers, fund boards) will need to be involved.”

What happened to BNY Mellon, added Mr. Korte, could happen to other custodians, because SunGard's InvestOne system is used by other providers.

“Most use this,” Mr. Korte said. ”It's got a reputation as a rock-solid system. It began as an installation problem, and the backup copy got corrupted, then it got serious fast. But they went back to an earlier version, and they'll be doing forensic testing, so they'll put in the work to try and make sure this doesn't happen again.”

State Street Corp. uses its own proprietary valuation system, said Anne McNally, a Boston-based spokeswoman. Officials at Northern Trust Corp., Chicago, would not comment.

Although not under contract with BNY Mellon and unaffected by the valuation issue, the problem led officials at the $15.7 billion Illinois State Board of Investment, Chicago, to look at its relationships with Northern Trust, its DC custodian, and State Street, custodian for the three defined benefit plans it oversees.

“When you see these kinds of things happening, you examine your own place,” said William Atwood, executive director.

Mr. Atwood said he wonders whether the push by DB plan executives for custodians to reduce costs is coming back to haunt them.

“ISBI has been at the point of the spear in driving custodial costs down, along with other pension funds,” he said. “My concern is that if we push pricing down, custodians still need to extract margin from the business, which means they might be cutting back on things. The risk is that the marketplace gets what it pays for.”

Mercer Sentinel's Mr. Korte said he doubted retirement plans would put BNY Mellon on watch because of the software issue, although “as a consultant, we would be bound to report on this in our due diligence with searches for custodians. If you thought about changing custodians before, this might give that a little push. But if you don't have a problem with BNY Mellon, this would not be driving the decision to up and go to market.”