Corporate Actions: Solving the Operational Disconnect

A capital charge, stock dividend, reverse stock split, tender offer or voluntary distribution.

Those are just a few of the dozens of types of corporate action events — many of them them voluntary corporate actions in which a decision must be made — that management firms have to handle on a daily basis.

Who has to deal with them? Everyone from the portfolio manager and research analyst all the way to the operations executives.

With so many players involved, it stands to reason that front and back offices need to be in sync. If they aren’t. the result can be less-than-optimal decisions or failures to deliver decisions at all, corporate actions specialists tell FinOps Report.  When no decision is made — which occurs as frequently as 50 percent of the time, according to multiple industry sources — the fund manager could be required to reimburse investors for lost profits. In a worst case scenario if failure of fiduciary obligation comes into play, regulators will also need to be appeased.

The risk of such outcomes is prompting fund management firms to recognize that corporate actions processing is going to require more attention and money. The challenge is to get front and back offices interacting properly with each other and with custodians. There could be a payoff to such investments. Some types of  corporate actions — voluntary reorganizations such as exchange offers, tender offers, and mergers — could even earn extra revenues for the fund managers.

The answer is pretty obvious: be more proactive through a combination of solid operational workflow management and trading savvy. While the current industry dialog on corporate actions processing is largely focused on adoption of the much-touted ISO 15022 or more advanced XML-based ISO 20022 messaging formats, standardizing the information formats only addresses external communications issues.

With the back-office serving on the first line as the gatekeeper, it is important that the process start off right. The fund management firm might have received the wrong information from its custodian, a data vendor or other source. If not caught and corrected, the error could move downstream into the books and records of the firm and eventually the portfolio valuation or even calculation of risk metrics and net asset value. It could also move upstream to influence trading activities.

Presuming the corporate action data is correct or will be quickly corrected, it’s now time for the next step. Or make that potential misstep, because ISO-formatted messages aren’t the norm.  “Back offices often communicate with front-office decision-makers through email or a proprietary internal portal,” explains Brendan Farrell, the New York-based executive vice president of SunGard Financial’s XSP unit, which provides corporate actions workflow software.

Even so, the right data might not even make its way from the back office to the front-office in an usable form — i.e. distilled down to what the front office needs to know. “Rather than sending an entire data file, the back-office will just include the information which is relevant to the investment management team,” explains Paul Fox, a director at corporate actions workflow management software provider Information Mosaic in Dublin. Relevant means which securities they are now trading or holding and the size of the position involved.

What might sound like a recipe for success isn’t, according to the gripes FinOps heard from fund management operations specialists. “It’s a time-consuming, partially manual, dangerously error-prone process to find our corporate actions in a datafeed, reformat the information for the front office, so the details of the corporate action and, if it’s a voluntary corporate action, the deadline for the decision are clearly spelled out,” says one fund operations expert. Yet another one says, “We only send reminders of when a decision must be made, because they [in the front office] are supposed to already have the same information we do.” When pressed to verify his stance, the operations specialist responds,” I think they do. We’re just told to send the reminders and nothing more.”

He Said, She Said

Some trading support staffers don’t seem any happier with the existing process. They are concerned about whether operations staff is promptly sending the correct information or just annoying them unnecesarily with reminders about deadlines for decisions in corporate reorganizations. “Granted, some corporate actions do offer money-making opportunities, but they are cumbersome to deal with, and we either don’t have the information clearly or if we do, we are harassed about the fact we have tight timetable,” says one trade support manager.

However, fund operations executives tell FinOps that they have no alternative, but to “harrass” their front office peers to meet the early decision deadlines set by custodians. They have to select either cash or a combination of cash and securities for their compensation in the case of a tender offer; exchange offer or merger offer. Depending on the type of corporate action event, there could be as few as two or as many as four choices.

If the fund manager hasn’t made a decision by the deadline, it will likely be given a “default” option by its custodian which could be “cash only” for some corporate actions or “no decision” when it comes to others such as tender offers. No decision means the fund management firm does not choose to participate in the tender offer, and could be on the financial hook to investors.

The Value of Time

If the fund manager does make a decision by deadline, knowing which compensation option to pick isn’t easy. In the case of cash, the fund manager will know and be guaranteed a certain amount of money depending on the size of its holding in a particular company. Not so, when it comes to any choice which involves securities. “The value of securities might drop from the time the fund manager makes its decision and the time it receives the securities. Or it could well increase,” explains Chris Kotsifas, president of STP Consulting Solutions, a Philadelphia-based consultancy specializing in corporate actions. “That means that the full value the fund management firm receives through the combined cash and securities will be either lower or higher than it would have with the cash alone.”

How does the fund management shop know what to do? It is at this stage where workflow management tools alone won’t be enough. The largest most efficient fund managers will typically have research analysts who work alongside portfolio managers to come up with future estimations of stock value. They are the same type of analysts — who might have once worked at large brokerages and banks — who help portfolio managers decide whether or not to buy, sell or hold a particular stock. However, smaller fund managers might not have a large enough research team to make such decisions, or might not consider corporate actions important enough to include in the research and trading strategy process.

What corporate actions software — such as that offered by Information Mosaic and SunGard’s XSP — do provide is a means of keeping track of what the corporate action is about, who is looking at the information, the opinion of the research analyst, and whether the portfolio manager abided by took that advice or ignored it. The only investment advice offered by most corporate actions packages is typically rudimentary — whether it will be in or out of the money based on the current price of the stock at the time a decision is made.

Better Late

Whether the fund management firm uses a present-value analysis, or goes more deeply into the impact of future volatility on pricing, time is going to be a critical factor in the decision-making processing. “Many front-offices are adamant that back-office managers pressure custodians to extend the deadline by which they vote on whether to accept cash or cash and securities,” explains Kotsifas. “The longer they have to make a decision, the longer they will have to evaluate just where the stock price is headed.”

In other words, the front-office wants to shave as much time as possible between the time it makes a decision and the deadline. Say a custodian imposes a deadline at 4PM EST to the fund management shop, but the custodian’s deadline to submit the corporate actions information is 5PM EST two days later. The portfolio manager will want to push the decision to as close to as possible to the custodian’s deadline to the depository, in order to monitor the price of the stock a long as possible.

Custodians want to give themselves as much leeway in the schedule, so they have sufficient time to compile all the decisions, process them and instruct the depository. It could even be three days in the case of foreign securities because of intermediary subcustodians and timezone differences. If the fund management firm is not yet communicating in ISO 20022 or at least the ISO 15022 message formats, or the custodian and local agent banks can’t process those formats, it could take the custodian additional time to interpret the responses. Such an inefficient scenario, of course, increases the potential for error.

Once the front office makes a decision, then what? It will send the decision to the back-office, which will then have to notify one or more custodians. If the decision is forwarded through the same email process that the information was sent or through a dedicated internal system, there is continuing risk of error. “It might never find its way into the back office, or a back-office executive might well forget to verify what decision has been made before the deadline with the custodian has passed,” explains Bjorn Schumberg, senior business consultant for investment management technology provider SimCorp in New York. If there is a breakdown in the process, the default option could be implemented without the front-office’s consent.

Automated Tracking

Given the complex process for handling voluntary corporate actions, it stands to reason that fund management firms might seek a dedicated corporate actions research analysts or specialists to oversee the entire lifecycle from the time the information arises to the time the decision is made and communicated back to the custodian. Sounds like a logical solution, but it isn’t a practical one based on the disparate front office research and trading analysis and the back office operational analysis required, explains Kotsifas.

The better alternative, says Schumberg: spend time setting up an efficient workflow process to ensure the back-office and front-office have the identical information about the corporate action as quickly as possible and know what decisions are made and when deadlines must be met. As proprietary emails and other internal communications channels aren’t ideal, corporate actions workflow software is one technological answer.

Yet another, Schumberg recommends is to rely on a single front, middle and back office platform which could produce an investment book of record (IBOR). However, as corporate actions specialists note, a purely position-based IBOR platform might not be enough if it doesn’t incorporate a communications function. SimCorp’s Dimension, says Schumberg, contains business logic to trigger communications between the front and back offices.

Regardless of how fund management firms decide to improve corporate actions processing functions, some preliminary steps are necessary. First is the internal agreement that corporate actions represent a source of potential income or loss that cannot simply be left to muddle along in a reactive mode. Then comes the need to more clearly understand the respective roles of the front and back office in the process, as well as identifying and fixing potential breaches in communications between them.

Last but not least, regular monitoring of how well the “relationship” is working wouldn’t be a bad idea. Fund management firms need to do a monthly post-mortem of their corporate actions process, what mistakes or even inefficiencies took place and why, recommends Schumberg. Getting problems on the table is halfway to fixing them.