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.
1) Regardless of where the execution occurs, prices for completed transactions in Nasdaq and NYSE-listed securities are reported to central utilities operated by their affiliates and then disseminated to the public on the Consolidated Tape.
2) The NYSE is the traditional floor-based exchange, while NYSE Arca is an electronic exchange. Although NYSE Arca is an affiliate of the NYSE, it is an exchange separately registered with the Securities and Exchange Commission.
3) The adopting release for Regulation SCI under the Securities Exchange Act of 1934 (Exchange Act), adopted by the SEC last year, identifies a number of recent instances in which exchanges – including options exchanges, as well as the securities information processor for Nasdaq-listed securities – have experienced outages due to technical problems.
4) Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder provide that the net asset value per share of an open-end fund must reflect the current market value of the securities that it holds for which market quotations are readily available, and the fair value of portfolio holdings for which market quotations are not readily available. In addition, subject to limited exceptions, Rule 22c-1 under the 1940 Act requires that a registered open-end fund calculate its net asset value per share every business day at a time or times disclosed in the fund’s prospectus. This rule also provides that investors must receive the net asset value per share next computed following receipt of a purchase or redemption request. Finally, Section 22(e) of the 1940 Act permits a fund to suspend the right of redemption if the NYSE is closed for other than customary closings or if trading on the NYSE is restricted.
5) While the NYSE normally closes for trading at 4:00 p.m. ET, it has abbreviated trading hours several days of the year, such as around Thanksgiving and Christmas when it closes at 1:00 p.m. ET. The hours of the NYSE are published well in advance.
6) An exchange (which includes Nasdaq) may issue trading “halts” intra-day for specific securities or all securities listed on the exchange due to volatility (e.g., circuit breakers), material news, etc. These trading halts are honored by other markets, and frequently a resumption of trading is published at the same time a halt is announced. The SEC also may “suspend” trading in a security for a 10-day period, and has emergency authority under Section 12(k)(2) of the Exchange Act to impose market-wide restrictions in the event of certain major market disturbances.
7) While the NYSE outage caught the market by surprise, the issues raised are similar in some respects to those that confronted many funds following Hurricane Sandy in 2012, when the NYSE also was closed.