Broker Dealers Beware: States Get Creative in Unclaimed Account Search

Knock, knock. Who’s there?

If a potential censure or fine from the Financial Industry Regulatory Authority or the Securities and Exchange Commission isn’t enough to motivate broker-dealers to ensure their middle and back-office operations are well oiled, perhaps an intensive audit by an unfamiliar firm sent by state regulators will be.

The states’ objective: taking over billions of dollars worth of unclaimed securities accounts and distributions.

States have apparently hired their own version of “debt-collectors” to verify whether broker-dealers are escheating — that is, transferring property held in unclaimed securities accounts when they should be. Just a fraction of the total pool of unclaimed property, unclaimed securities accounts, are a cash cow for states. They can use the funds from liquidating the account assets to fill budget gaps, if the rightful owners of the unclaimed property do not step forward. In 2011 alone, the fifty states and District of Columbia collected a whopping US$5.8 billion in unclaimed property.

Even if investors do eventually try to take back their accounts, they could spend months trying to collect their monies and end up recovering only the value of the account at the time it was escheated by a brokerage firm — not its current value. The fifty states and District of Columbia paid out close to US$2 billion to owners of unclaimed accounts in 2011.

The payoff for state audit firms digging into the files of a broker-dealer can be substantial — between ten and fifteen percent of the value of the accounts they discover that should be escheated, say unclaimed property experts. That could easily come to over US$300 million a year for just one state. However, for broker-dealers, complying with federal and state regulations can be a tangled operational nightmare including almost unavoidable risk of legal liabilities, according to a new white paper issued by the influential trade group Securities and Financial Markets Association (SIFMA).

” ‘Unclaimed Property Obligations and Challenges for Broker-Dealers‘ seeks to inform our members and investors of the current unclaimed property regulatory landscape. Specifically, the white paper is designed to stimulate dialogue about how best to modernize and improve the unclaimed property regulatory landscape and provide a torchstone for a firm’s unclaimed property discussions with customers and clients,” says a statement to FinOps Report issued by Will Leahey, SIFMA vice president of operations and technology. He referred further questions to the white paper.

While SIFMA is promoting the white paper as simply educational in nature, it was reportedly commissioned by its clearing firms committee and its tone clearly reflects the urgent concerns of introducing brokers as well. Both groups have reason to worry about the more aggressive tactics being used by third-party auditors, such as Verus Financial, hired by the states. As a result of state settlements resulting from these audits, broker-dealers are facing far more work in searching for the so-called lost accountholders than even the Securities and Exchange Commission guidelines.

Al Caiazzo, managing director at First Clearing Correspondent Services, who was appointed chair of SIFMA’s clearing firms committee in January 2013, could not be reached for further comment. He no longer holds that position and his successor could not be determined at presstime.

A settlement reached in December 2014 between Morgan Stanley and over 30 states, led by California, calls for the brokerage to perform “due diligence” on all unclaimed accounts prior to reporting and escheating them — a process which must include a “Dear John” letter to account owners at their last known address on the brokerage’s records. If the address is known to be wrong, then Morgan Stanley must rely on national databases, such as the US Post Office database of changed addresses, to do its search. That is unless it discovers the client is dead through checking the Social Security Administration’s death database. At presstime, Charles Schwab had also reached a similar settlement with the state controller in California, which only applied to that state. Schwab officials declined to comment for this article.

New Baseline for Due Diligence

At the heart of all the settlements is the premise that brokerages should follow the same new due diligence, as life insurance companies now face the same dire consequences for failing to escheate unclaimed assets. Among the litany of firms affected in the multi-state agreements were John Hancock, New York Life and TIAA-Cref.

“First, insurance companies, now brokerage firms are the target of the Verus brand of contingent-fee state auditors, and broker-dealers need to pay very close attention to their procedures involving unclaimed property in securities accounts,” warns Mary Jane Wilson-Bilik, a partner with the law firm of Sutherland Asbil & Brennan in Washington DC. “Motivated by their potential compensation that depends on the amount of money they bring into state cofffers, state audit firms, such as Verus, will come up with novel interpretations of whether an account is unclaimed.”

“The requirements established by the settlement have established a costly precedent for broker-dealers,” explains Kimberly DeCarrera, general counsel for Atlanta-headquartered Barganier, which helps corporations prepare for state audits and reports on unclaimed property. Although she could not quantify the costs, she says they include the expense to access external databases and improve internal procedures.

One of a handful of audit firms paid by states to investigate whether companies have fulfilled their legal obligations with regard to unclaimed accounts, Verus Financial in Westbury, CT declined to comment for this article. “We are pleased to work with the state controller in the best interests of all parties.” says a terse statement issued to FinOps by Morgan Stanley’s press office.

The task of complying with unclaimed property rules is a cumbersome one even for the best organized firms. First an account must be established as unclaimed or abandoned, the correct dormancy period must be applied, and last but not least there must be some proactive last-ditch effort to track down the account owner. When all else fails, the account must be reported and “escheated” to the state of last known address. If there is no last known address, the account must then be reported and transferred to the state in which the company — or issuer of the securities — was incorporated. Delaware and New York are the most common.

Both the SEC and state laws apply when it comes to determining whether to mark an account as unclaimed and what due diligence process to use to track down a lost securityholder. However, only state laws apply when it comes to which dormancy period to use and when to transfer an unclaimed account to a state, which requires plenty of paperwork to fill out.

Accounts typically become unclaimed when the owner changes address and does not notify the brokerage or dies without a beneficiary on the account. Those “triggers” to search for the client are the easiest to prove because mail could be returned as “undeliverable,” or a check might be uncashed. But when a state defines the guidepost as “inactivity,” broker dealer compliance specialists could easily be left scratching their heads in dismay. Delaware is often criticized as having the most liberal interpretation of the term, which may be nothing more than the lack of communication by an investor in a dividend reinvestment program, whether or not the investor would logically have reason to contact his or her broker-dealer.

Dormancy periods are also subject to state interpretation depending on the type of account and distribution, generating at least several dozen different permutations. “Broker-dealers might not be able to operationally keep track of whether an unclaimed account has passed the dormancy period and must be reported and escheated to a state,” explains David Boch, a partner with the law firm of Morgan Lewis & Bockius in Boston. “To do so they would have to match up each account and each unclaimed distribution with the dormancy period.”

The penalties: other than reputational risk with the investors and rising compliance costs involved with the higher standard of due diligence in tracking down unclaimed account holders, financial penalties are a distinct possibility. Some states, such as California, will assess daily penalties and interest on unclaimed accounts not reported to the state in a timely fashion. The clock starts ticking from the day the unclaimed property should have been reported.

Course of Action

Whats a broker-dealer to do? Familiarize itself with the SEC and state regulations is a good idea for starters. DeCarrerra recommends that broker-dealers review DRIP accounts and accounts established for minors first as they may be the ones most subject to claims of inactivity. “Sending out a letter to the shareholder asking for active contact in the form of an explcit response by writing or through a phone call to customer service would be sufficient to reestablishing contact,” she says. Next in line: all the other accounts, including retirement accounts. The optimal goal, says DeCarrera is to maintain records of all investor activity at a detailed level.

Just how far back should broker-dealers research their procedures and records? At least ten years for starters but for accounts which might be escheated to Delaware, going as far back as 1981 will be required, says DeCarrera. The problem: brokerages typically only keep records for ten years at most.

Next up: review contracts with clearing firms to understand just who has ownership of the necessary data and who is responsible for tracking down unclaimed account owners. “Contracts with clearing agents differ widely when it comes to how unclaimed accounts will be handled,” explains Holly Smith, a partner at Sutherland Asbil & Brennan.

Among the possible scenarios brokerages may have to deal with: a contract that is silent on whether the introducing broker or the clearing agent is responsible for complying with unclaimed property rules. Which will get audited? Try both. “States are hungry for the money involved in unclaimed accounts and could go after both the introducing and clearing broker,” says DeCarrera.

Word to the wise, the operations manager at a US clearing firm tells FinOps: “It’s time now to verify whether your introducing broker or clearing firm will be responsible for sending out due diligence letters, confirm who will be responsible for declaring an account as unclaimed, who will monitor the dormancy period, and who will do the final transfer or escheatment of the account to a state.”

What’s more, don’t think that compliance with unclaimed property rules can simply be delegated to a back-office operations team as an administrative afterthought. “Broker-dealers need to gather operations, legal and compliance specialists at the same table to review their process and how it can be improved before state auditors come knocking at their door,” recommends Boch.

Finally, keep your eye on the ball in terms of customer service. The problems might not only originate with the regulators and their hired auditors.  “Customers, whose accounts are erroneously escheated, make for very unhappy customers and potential litigants,” points out DeCarrera.