Investment Fund Transfer Agents: Forget About Monitoring Brokers

The US Securities and Exchange Commission has the right intention in wanting to update its outdated rules for transfer agents, say investment funds transfer agents and their legal counsel, but its approach in regulating shareholder recordkeepers of buy-side firms may be flawed.

Among the growing list of concerns is whether investment fund transfer agents might be required to more closely oversee the activities of subtransfer agents — the broker-dealers and banks through which investors buy and sell shares. Investment fund transfer agents simply don’t have enough information, nor do they have the legal or business clout to require broker-dealers and banks to hand over the necessary information.

Their worries are not based on a specific rule, but rather inference from the language of an advance notice of rulemaking and concept release issued in late December 2015. In the notice, the US regulatory agency suggested it might either mandate that transfer agents for registered investment funds — namely mutual funds– comply with the same rules as equity transfer agents or it might impose new rules. The rules for equity transfer agents have not been materially changed since they were implemented in 1977 and those never specifically addressed mutual fund transfer agents, who have relied on best practice. So far, they have been legally exempt from the basic turnaround, processing and recordkeeping rules of equity transfer agents.

As FinOps Report goes to press, no transfer agents had publicly expressed their views on the SEC’s request for feedback on its advance rulemaking notice. Instead they have asked for 60 more days to comment beyond the February 29 deadline, because the SEC posed far too many questions to digest quickly. The SEC has obliged, extending the deadline to April 14.

Registered investment funds rely on internal units shareholder recordkeeping, or outsource it to one of  handful of external firms that handle this work. With the growing trend for investors buy and sell shares of investment funds through broker-dealers and banks, those financial intermediaries also handle administrative tasks for shareholder accounts.

In its concept release, the SEC never specified just what oversight, if any, it wanted mutual fund transfer agents to exercise over financial intermediaries or subtransfer agents. However, it was clear that the regulatory agency is thinking about the respective roles of the two types of services providers, while highlighting the lack of transparency in how the subtransfer agents perform their shareholder services work. In an apparent fishing expedition, the SEC used the concept release to request more information from investment fund transfer agents on how subaccounting agents handle beneficial investors, leaving investment fund transfer agents to fear the worst.

“Practically speaking, we don’t know how the SEC would expect us to monitor subtransfer agents,” says one operations manager at the transfer agency unit of a US mutual fund complex. “Under current circumstances, we have no way of doing that.”

Although the SEC may not have explicitly indicated what it has in mind, the concept release’s timing, coupled with other SEC guidance on the role of mutual fund transfer agents in monitoring fund distribution fees, suggests the SEC might want to require investment fund transfer agents to play a greater role in overseeing subtransfer agents, agrees John O’Brien, a partner with the law firm of Morgan Lewis & Bockius in Philadelphia.

Brewing Thoughts    

In a guidance letter issued to mutual fund directors last month, the SEC’s Division of Investment Management urged them to put in place procedures to evaluate whether the subaccounting fees that funds pay brokers and other intermediaries are being used to boost the sale of funds. SEC rules call for subaccounting fees to only be used for shareholder administrative services such as recordkeeping, answering customer questions, and providing account and tax statements. The SEC is worried that the fees paid by funds for subaccounting services are being disguised as distribution fees, so investors won’t really have a clear sense of the distinction and can’t make informed decisions on whether to buy shares in the mutual fund.

By resurrecting the broader issue of how subtransfer agents are servicing their shareholder accounts in its concept release, the SEC is acknowledging the difficulties investment fund transfer agents will have in making sense of the services of subtransfer agents. “One of the industry criticisms coming out of the guidance update was that it emphasized the importance that boards receive information on services provided by third parties down the chain to end investors and the value ascribed to those services,” says O’Brien. “However, the SEC downplayed the market reality that there is currently no way to obtain that information. By taking a more holistic approach, the SEC has identified this gap as an area of concern and is undertaking a more thoughtful approach in evaluating the magnitude of that concern.”

Under current regulations, all that fund transfer agents can tell investment funds about how Street-name investors are being serviced are the “omnibus” names of the broker-dealers or banks through which the investors bought and sold their shares. The transfer agent of the investment fund can always ask the broker-dealer or bank for a list of the underlying investors, but cannot force financial intermediaries to cough up the names Nor can it require financial intermediaries to provide more details on how they do their jobs or the fees earned.

Broker-dealers and banks don’t want mutual funds knowing the names of the beneficial shareholders, because financial intermediaries believe they, not the mutual fund, own the client accounts. The financial intermediaries fear that if mutual funds can communicate directly with investors they would be cut out of the picture. A less discussed, but touchier outcome, is the potential for investment funds to question the validity of the subaccounting fees they must pay.

“If financial intermediaries are not required to provide the necessary transparency for a mutual fund transfer agent to perform the required oversight, neither the mutual fund nor it transfer agent will have a clue who the underlying investors are,” says Timothy Johnson, a partner with Reed Smith in Pittsburgh.”Unless the SEC mandates that transparency, it is unlikely that requiring oversight by mutual fund transfer agent will be an effective fix to the Commission’s concern.”

At the very least, according to Johnson, the mutual fund’s transfer agent must know the number of subaccounts or individual investors serviced and precisely what services are being performed. “That [knowledge] will help the mutual fund’s transfer agent and board determine whether the mutual fund is paying a reasonable subaccounting fee. Without that information, an apples to apples comparison will be quite difficult,” he says.

Speak Up Now

Given that the SEC is looking into the relationship between investment fund transfer agents and subtransfer agents, shouldn’t investment fund transfer agents start preparing? Unfortunately, they can’t because they don’t know what the SEC will want. However, they should take the opportunity to ask the SEC to address either the operational issues they are worried about or to clarify the SEC rules that have historically caused them the most angst, recommends Johnson.

One problematic issue, raised by case involving insurance giant Nationwide and reported by FinOps (May 19, 2015: Want to Price Shares Late: Get the Post Office to Help Out) involves the definition of “orders received” and the timing of when to open physical mail received at a post office in a location different from the investment fund transfer agency’s operating location. For 16 years, Nationwide intentionally arranged to postpone receiving and opening its mail until after 4PM EST, a delay mutual fund operations experts told FinOps would likely have helped the insurance giant manage its operational workload and not harmed investors. However, the SEC fined Nationwide US$8 million for violating Rule 22c-1 of the Investment Company Act of 1940 which says that orders from investors in mutual funds received before 4PM EST on a business day must be priced on that day. The underlying mutual funds in the variable annuity and variable life insurance policies are only available through separate accounts sold by insurance companies such as Nationwide. Hence, they must follow the same rules as mutual funds.

However, as Johnson explains, there are no clearcut regulations on when investment fund transfer agents must retrieve their mail or any guidance on what the phrase “orders received” really means. Mutual funds typically receive mail when they think it is available from the post office and the time of availability can differ.

“Mutual fund and their customers would be better served if the SEC were to provide clear guidance on the matter rather than bring enforcement action,” says Johnson. “It would be helpful to the industry if at least that was one of the outcomes of the advanced notice of proposed rulemaking.”