The New York Stock Exchange (NYSE or Exchange) was forced to suspend trading for almost four hours on July 8, 2015 to resolve a technical problem that resulted from a software upgrade. The Exchange resumed normal trading operations prior to the Exchange’s regular close at 4:00 p.m. ET.
The outage was significant both in terms of its effect (or lack thereof) on the market for NYSE-listed securities, as well as for the questions the event raised for open-end funds registered under the Investment Company Act of 1940 (1940 Act) – in particular, with respect to the valuation of fund portfolio holdings, pricing of fund shares, and processing of transactions in fund shares.
Changes in equity market structure caused by technology and regulatory reforms have resulted in a decentralized market for securities. When a market such as the NYSE is not operating, and individual securities are not subject to “market-wide trading halts,” then price discovery still occurs and orders may be executed internally by brokers (or their affiliates), or routed to competing market centers (including other exchanges, as well as alternative trading systems).1 For example, when the NYSE suspended trading on July 8, its affiliated electronic exchange, NYSE Arca,2 continued to operate, and executions in NYSE-listed securities took place on NYSE Arca, Nasdaq and many other transparent market centers. In addition, transactions occurred in “dark pools.” Moreover, trading in Nasdaq-listed securities largely was unaffected by the NYSE outage.
Outages are not uncommon among exchanges and other market centers.3 The recent NYSE problems follow a well-publicized outage at Nasdaq two years earlier. From a structural perspective, however, the fact that trading in NYSE-listed securities continued seamlessly on other market centers underscored the benefits of competing markets that do not have a “single point of failure.” Even during the outage, investors were able to receive pricing information and obtain executions on NYSE-listed securities from other markets.
Fund Pricing and Operations
Despite the nominal effect that the NYSE outage had on actual execution quality, it did raise concerns for funds based on their valuation and pricing mechanisms set forth in fund prospectuses and procedures that are typically tied to the regular close of the NYSE.4 Many funds disclose in their prospectuses that shares are available for purchase and redemption each day on which the NYSE is open for trading, and that net asset values per share are determined as of the close of regular trading on the NYSE.5 Thus, the trading days and trading hours of the NYSE frequently govern the operations of funds, as well as the valuation of portfolio securities listed on the NYSE, Nasdaq and foreign markets, and traded on the debt markets.
These typical fund valuation and pricing provisions are likely based on the historical paradigm that trading which occurred away from the NYSE would not reflect price discovery in a competitive market, and that the operation of the NYSE, in particular, was a proxy for overall market conditions. However, as a result of changes in market structure, the NYSE’s market share of transactions in NYSE-listed securities has gradually eroded from 80-90% to less than 20%, and the operation of the NYSE no longer serves as a proxy for a largely diffuse, but interconnected, electronic market for equity securities.
Accordingly, fund valuation and net asset value calculation provisions that key off of the “close” or “close of regular trading” (or similar provisions) of the NYSE without further explanation, may raise questions in instances such as July 8 – where trading is suspended by the Exchange earlier in the day, for technical reasons and not as part of a trading halt that is effected on a market-wide basis.6 Had the NYSE not resumed trading prior to the regular closing on July 8, certain funds – by the terms of their prospectus or procedures – may have been required to value portfolio holdings, for both NYSE-listed and Nasdaq-listed securities, as of the time of the suspension of trading by the NYSE (approximately 11:32 a.m. ET), or utilize fair value pricing based on the change in values between the suspension of trading on the NYSE and 4:00 p.m. ET.
In addition, depending on a fund’s prospectus disclosures, a failure of the NYSE to effect a “regular close” at 4:00 p.m. ET may have impacted the fund’s processing of purchase and redemption orders received after the suspension of trading on the NYSE. For example, if a fund continued to accept purchase or redemption orders until 4:00 p.m., but priced off of the 11:32 a.m. suspension of NYSE trading (assuming the fund determined it was permitted or required to do so), an arbitrage opportunity may have been presented for investors. However, it may have been difficult from an operational perspective to stop processing fund share transactions intra-day based on the NYSE’s trading suspension – particularly when it was not known if the NYSE would resume trading prior to the close.
Considerations for the Future
It is important to note that the recent NYSE outage was due to a technical emergency encountered by the Exchange with respect to its facilities, and was not a trading halt in an individual security or all NYSE-listed securities due to an event (such as tripping a circuit breaker) that would have restricted trading and price discovery on other markets. In light of both the inevitability of system outages and the manner in which trading has evolved away from the floor of the NYSE, fund sponsors may wish to discuss with their pricing services the effect of the NYSE outage.7 Fund sponsors may also wish to review valuation policies and procedures, and prospectus disclosures regarding pricing and the processing of transactions – to the extent historical pricing conventions are used that today may elevate form over substance. More generally, fund sponsors should ensure that existing policies, procedures and disclosures accurately reflect applicable legal requirements and the practical issues associated with pricing and fund flows from intermediaries, as well as the fund sponsor’s intent in such instances.