Transfer Agents: Preventing Fraud a Delicate Balancing Act

The work of stock transfer agents may require a lot of detail management, as well as complex interactions with issuers, shareholders and various intermediaries, but the field isn’t likely to be associated with investor fraud. That is, until now.

Two commissioners at the US Securities and Exchange Commission are urging the agency to take a harder look at the otherwise sleepy business of transfer agents and come up with new and improved rules. Although the SEC has been dragging its heels for several years over reviewing the policies governing the transfer agents, it may have finally nailed a better reason to get something done. Transfer agents may be the first line of defense against investor fraud associated with microcap stocks, which is made possible if corporate insiders or large shareholders in microcap companies can succeed in illegally lifting restrictions that keep private stock from being publicly traded.

The idea of transfer agents acting as gatekeepers was buried in a multitude of suggestions issued in a joint statement by SEC Commissioners Luis Aguilar and Daniel Gallagher acknowledging that the antiquated rules governing transfer agents needed to be changed. Transfer agents have been subject to rigorous recordkeeping rules since 1934, but now need to think about minimum insurance coverage, disaster recovery plans, policies for addressing conflicts of interest and segregating client funds they say.

But it is clearly the transfer agents’ administrative role in lifting sale restrictions which has caught the SEC’s eye as shown in a recent penalty against a transfer agency and its chief executive. It is also the role which could prove to be the most contentious for the SEC to resolve. Despite their show of public support for the SEC’s resurrected interest in their work, transfer agents privately fear that taking on fiduciary responsibilities could create costly, if not impractical changes to implement.

With about 450 registered transfer agents maintaining 276 million registered shareholder accounts for 1.5 million corporations, transfer agents represent a sizeable industry sector. While the SEC has reportedly been thinking about issuing a high-concept release requesting industry feedback on the issues — a typical first step when opening a new or long neglected area of regulation — the two SEC commissioners suggest that the SEC’s Division of Trading and Markets needs to get right down to adopting some new rules.

“The SEC has now realized that as more shareholders hold their accounts in electronic rather than certificated form and the US is considering a reduction in the settlement cycle to two days, the rules for transfer agent rules need to be quickly revised, ” agrees Charles Rossi, who chairs the Security Transfer Association’s Board Advisory Committee.

The last attempt at holding stock transfer agents to higher operating standards came indirectly in 2009, when a proposed rule change was submitted to the SEC by the Depository Trust & Clearing Corp., the US umbrella organization for clearance and settlement. The DTCC was trying to beef up the requirements it imposed on transfer agents participating in a DTCC-operated program allowing investors to hold their accounts in dematerialized form. However, the DTCC’s proposal failed, as the SEC bowed to  lobbying from transfer agents who countered that the SEC, not the DTCC, should regulate their business.

Why Now

Fast forward by five years and the SEC has come to the conclusion that transfer agents are in a position to proactively combat microcap fraud. The Financial Industry Regulatory Agency (FINRA), the broker-dealer self-regulatory organization, has cited examples of fraud in which holders of restricted securities were able get the legends, or ownership restrictions, on such securities lifted by transfer agents unaware that they were helping perpetuate fraud.

Yet another reason for placing more watchdog responsibilities on the transfer agents: “Given that many companies are choosing to stay private longer and undertaking many more rounds of private financing, it is only natural that the SEC take a closer look at transfer agents,” says Anna Pinedo, a partner in the law firm of Morrison & Foerster in New York.  The greater the number of classes of restricted stock the greater the potential for fraud.

In addition to earning their bread and butter from administrative tasks like issuing stock certificates, paying dividend and managing dividend reinvestment plans, transfer agents are also responsible for helping shareholders change the status of accounts from restricted to public so they can eventually sell the shares.  If those planning to commit fraud can mislead transfer agents into removing the restrictions, unregistered shares, which are not supposed to be sold to the public under federal law, could end up being eligible for trading. Once that happens, con artists can “pump and dump.” That is, artificially driving up the stock price by releasing false information to lure investors into buying shares, then dumping their own shares on the unwary investors at the inflated prices before they tank.

Microcap companies are considered the most susceptible to fraud and, typically with constrained budgets, they hire smaller, less capitalized and less operationally sophisticated transfer agents. With fewer internal resources, these transfer agents may be also more likely to become unwitting accomplices by not recognizing inadequate paperwork to remove share restrictions. “In light of the fact that the SEC does not have specific rules addressing their duties, transfer agents have differing practices, which could ultimately cause regulatory action should the SEC not agree that the agents’ procedures were adequate and something goes wrong,” says Edward Pittman, special counsel with the law firm of Dechert in Washington, D.C.

Setting an Example

In its familiar method of using a particularly harsh or well-publicized enforcement action to put an industry sector on alert, the SEC did exactly that. Rather than using specific breaches of rules to trigger the enforcement action, it used the premise of “aiding and abetting” investor fraud to penalize Register & Transfer, a New Jersey-based mid-sized transfer agent and its CEO last September. From the SEC’s account of events, R&T enabled Heathrow Natural Food & Beverage’s unauthorized distribution of shares and missed blatant red flags indicating wrongdoing. R&T’s chief executive Thomas Montrone was cited for insufficient supervision of employees. “R&T’s employees were trained to do little more than check boxes on a form and for more than two years rubber stamped [CEO Michael] Pagano’s repeated unlawful requests to issue stock,” says the SEC.

What has transfer agents a bit peeved is that not only did R&T, now owned by mega transfer agent Computershare, ended up paying $127,000 in penalties,disgorgement and interest, but also Montrone had to pay a fine of $25,000 and agree to be banned from taking a supervisory role at another transfer agency for a year. Transfer agents contacted by FinOps Report were quick to sing Montrone’s praises, noting his unblemished twenty-five year track record in the transfer agency industry. “The SEC doesn’t have any clearcut rules on how transfer agents should be preventing investor fraud,” argues an angry operations manger at a US transfer agent, “but now we’re supposed to also look at what happened to Registrar & Transfer and Mr. Montrone and do exactly what?” Pittman says that from his personal perspective, the SEC’s decision against Montrone is a “disservice” to the industry.

Transfer agents insist the threat of fines and censure are not balanced by clear guidance from the SEC. “We would like to help the SEC prevent investor fraud as gatekeepers, but without objective standards or clear guidance telling us what to do, we are in a bind,” says Kara Kennedy, executive director of Lutz, Florida-based transfer agent ClearTrust, which serves small public companies and community banks. “Making matters more difficult for transfer agents are inconsistencies between the SEC’s expectations and state regulations governing requests to process share transfers and legend removals.” Federal laws might suggest transfer agents can refuse to process a request for removal of a legend if they suspect fraud, but state law might require the transfer be completed if the paperwork is presented in good form. The transfer agent is left in a Catch- 22 situation.

Finding the red flags of potential wrongdoing can be subjective and various SEC’s regional offices have come up with different interpretations, making it difficult to know what to do, gripe operations directors at other US transfer agents. In its settlement with R&T and Montrone, the SEC doesn’t provide any specific recommendations on what transfer agents should do, yet it warns it won’t tolerate transfer agents who are reckless in their responsibilities. “Transfer agents serve a pivotal function in the issuance of securities and their employees must be prepared to catch frauds, not enable them,” says the regulatory agency. “As we continue our crackdown against those who play central or supporting rules in a microcap scheme, transfer agents must ensure, they have the appropriate systems in place to detect red flags and prevent law violations like the ones that occured with Heathrow.”

There are no official figures on how often transfer agents refuse to handle transfer requests they think are fraudulent or how much they make from the work. Some charge a flat rate, some an a la carte rate and others not at all. However, they are adamant they would rather lose revenues than face legal action for even unintentional wrongdoing.

Think Twice

Despite the lack of explicit rules from the SEC, there are some best practices transfer agents can follow, says Kennedy. They can start off asking for an opinion of counsel when changing the status of shares for a holder from restricted to publicly tradeable. Opinion of counsel is a fancy phrase referring to the legal firm representing the issuer confirming that the shareholder’s paperwork is in order so the transfer agent can go ahead to remove the “legend” from the shares.

However, if a transfer agent takes the issuer’s law firm opinion as definitive, it has no reassurance that the opinion is really legit. “There are some unscrupulous law firms which will provide opinions of counsel,” acknowledges Pittman. “Therefore, the transfer agent should look carefully at the quality of the opinion.”

That close scrutiny should include uncovering discrepancies, of which the most critical might be differences between the information cited on the opinion of counsel and other documents provided by the shareholder. In the case of Heathrow, says the SEC, the shareholder requesting the issuance of shares was not the shareholder covered by the attached opinion letter. Yet other warning signs, according to Kennedy: the legal opinion may say the shares were owned by the seller for a year, but payment was paid only for a few months earlier. Alternatively, the shareholder might acquire shares and immediately attempt to distribute them to multiple third parties. Or an investor wanting to sell shares is located in one country while the stock power was endorsed in another.”It all comes down to training employees to be on the lookout,” explains Kennedy.

Just what will the SEC finally decide to do is anyone’s guess. Transfer agents and their legal counsel predict that the regulatory agency will have a far easier time coming up with rigorous operating rules when it comes to data recovery and other operational issues than devising rules to prevent shareholder fraud. “They would still be subject to interpretation and thus vulnerable to enforcement actions. So the transfer agents and issuers are likely to push back hard,” says one legal expert.