Compliance directors at US mutual fund transfer agents and US mutual funds will have to follow the US Securities and Exchange Commission’s rules to a T and they will have more administrative work on their hands to inform investors about the perils of escheatment of unclaimed or “lost” accounts, based on the US Securities and Exchange Commission’s controversial settlement with DST Asset Manager Solutions.
The SEC recently fined DST Asset Manager Solutions, the US’ largest transfer agent for mutual funds, US$500,000 for violating Rule 17Ad-17 from January 1, 1997 to July 31, 2022 which resulted in the accounts of 78 investors being escheated to state coffers. The value of the accounts transferred came to about US$651,000. DST was purchased by SS&C Technologies in 2018 and as of the end of 2022, it serviced about 100 mutual fund companies representing a little over six million individual shareholder accounts.
About one in seven people have over US$70 billion worth of unclaimed property held by state treasury departments, according to the National Association of Unclaimed Property Administrators. That property ranges from uncashed paychecks to inactive securities accounts. Transfer agents typically keep books and records indicating ownership of accounts, and they send out dividend checks. They must follow a combination of SEC and diverse state regulations in dealing with lost accountholders.
SEC rules dictate what a registered transfer agent should do to track down lost accountholders, while state rules mandate when the transfer agent or other financial institution can mark an account as lost– aka abandoned– and when to send it to a state coffer. The dormancy period for states is often three years and depending on the state the clock starts ticking either after two mailings to an investor are returned to a transfer agent as undeliverable, or when an investor does not communicate with a transfer agent. States generally do not consider automatic investment or redemption plans as meeting their interpretation of contact on a mutual fund account.
The revenue from liquidating unclaimed accounts is a cash cow for states and a potential cash loss for investors. States can use the funds from unclaimed property to close their budget gaps so they will typically sell stocks and bonds in unclaimed securities accounts quickly upon receipt. Investors trying to claim their accounts down the road will receive the value of their accounts at the time of liquidation and will not benefit from any increase in value or even subsequent dividend or interest payments. States do make some effort to notify the public about the unclaimed accounts, but only a fraction of the funds from the accounts are ever returned to their rightful owners. Each of the states has its own rules for claiming the accounts, which involves an investor proving ownership.
Adopted in 1997, Rule 17Ad-17 requires transfer agents registered with the SEC to take “reasonable care” to track holders of lost securities accounts by finding better addresses for them when their mail is returned as undeliverable twice. The transfer agent can search for a better address through databases either using the taxpayer identification number– typically social security number — of the investor, or if it doesn’t think that will provide a better address, use the name of the investor.
DST’s written policy was to verify the address it found was accurate by matching the address of the investor with the first name of the investor on its records. However, the firm did not follow its written policy, according to the SEC. Instead, DST further filtered its search by matching the address of the investor found with the first AND last name of the investor on DST’s books. Because they never received any notification, some investors had their accounts escheated to states unnecessarily.
In its settlement with DST, the SEC calls DST’s written policy deficient and its practice even worse. “The written procedure violated the Rule which requires that a name should only be used when a social security number search is not reasonably likely to locate the security holder,” writes the SEC. The regulatory agency further notes that SEC’s practice also violated the SEC’s rule and further reduced the universe of “lost” securityholders to be contacted by DST. To settle its dispute with the SEC, DST agreed to its terms without admitting or denying any wrongdoing.
The financial terms of the SEC’s decision aren’t the most significant outcome of its settlement with DST. What is even more problematic, for mutual funds and their transfer agents, are the additional requirements imposed by the SEC’s Division of Enforcement, with which two Republican SEC Commissioners disagree. In a statement, Commissioners Hester Pierce and Mark Uyeda say that one of the regulatory agency’s guidelines for DST to meet equates to mandating an entirely new requirement for all mutual funds, through enforcement action rather than a new rule. The SEC ordered DST to request that its mutual fund clients send out periodic notices to shareholders informing them of the risk their accounts may be escheated and educating them on how to avoid that fate. Another requirement was that DST keep documentation for five years proving it is complying with the SEC’s order. The five years begin as of September 1, 2023.
“The word request [in the notification requirement] implies a level of flexibility that is contradicted by further language in the order requiring the firm [DST] to certify in writing compliance with the undertaking,” write Commissioners Pierce and Uyeda in their dissent. If a mutual fund receives a request from its transfer agent based on the SEC’s ruling, the fund counsel will see it as tantamount to a requirement, according to the commissioners. The SEC’s order for DST, the Commissioners explain, implies that all mutual funds upon being prompted by their transfer agents must send periodic notices and educate their investors about how to prevent their accounts from being escheated to states. That outcome isn’t exactly fair for either transfer agents or their mutual fund clients, say legal experts.
“Rule 17Ad-7 does not impose any responsibilities to mutual funds when it comes to disclosure about potential escheatment of unclaimed accounts,” Jennifer Borden, a Boston-based attorney specializing in unclaimed property tells FinOps Report. “The mutual fund transfer agent could be held liable if its client doesn’t make the disclosure and so could the mutual fund company.” What’s more, in its settlement with DST, the SEC offers no guidance as to what mutual funds should write in their periodic notices about the potential for escheatment or whether the subject should be discussed in a mutual fund’s offering document.
In a recent article posted on its website, the law firm of Ropes & Gray notes that many mutual funds already explain that unclaimed mutual fund accounts could end up escheated to states. In light of the SEC’s settlement with DST, the law firm offers the following recommendation– “Funds that do not already disclose escheatment risk may want to consider adding appropriate disclosure.”
Although the two SEC Commissioners opposing their regulatory agency’s decision focused their written comments on the additional burdens for mutual funds and their transfer agents concerning disclosure on the perils of escheatment, they also question the merits of the SEC’s enforcement action with regards to its civil penalty. In a footnote in their public statement, the commissioners call the SEC’s interpretation of Rule 17Ad-17 “strained” and suggest that DST did not violate the rule. They reason that is that Rule 17Ad-17 does not prohibit a transfer agent from verifying an address for a “lost” investor by matching the first AND last name of the accountholder with the address on its records. In fact, the practice prevents identity theft should a mailing be sent to the wrong individual or entity.
So what did DST do wrong? By the opinion of the SEC’s Division of Enforcement, DST should have simply sent out notices to reconnect with “lost” accountholders” to the addresses matching the social security numbers they had on file rather than doing more filtering based on the first and last names of the accountholders as well. Even if well-intentioned, DST should have followed the strict letter of the law and forgotten all about what it thought was a better process.
Industry reaction to the SEC’s decision is mixed, with some compliance managers at mutual fund companies telling FinOps Report that they agree with the SEC’s fine, while several others saying they disagree. Some who agree with the SEC’s decision say that the SEC should have insisted that DST reimburse “lost” accountholders for the current full value of their accounts. Regardless of their opinion, all of the dozen compliance managers express concern about the ramifications of the SEC’s ruling on their firms. Following the terms of the SEC’s settlement with DST as their own policy could spell higher costs which could ultimately trickle down to investors. The additional expense results from mailing more notices to investors, consulting with external legal counsel on how to implement disclosure about escheatment, and spending more time looking for “lost” accountholders.
Borden, who frequently works with the Securities Transfer Association on unclaimed property regulations, commends the SEC for enforcing Rule 17Ad-7 to reduce the number of accounts being escheated to state coffers. However, she believes that a better solution would be for the unclaimed property auditors of some states — such as Minnesota and Delaware– to not impose an unofficial mandatory escheatment policy for accounts which are merely inactive before the state dormancy period ends. Such a practice does not allow investors to benefit from the enforcement of Rule 17Ad-17.
Because they are paid on a contingency basis — a percentage of the value of accounts escheated to a state — state auditors can be aggressive in marking an account as ripe for escheatment when it is not. Avoiding Rule 17Ad-17 helps auditors rather than investors, says Borden.
The Investment Company Institute, the influential Washington, DC-mutual fund trade group, has not taken a public stance on the SEC’s order concerning DST. Its website (www.ici.org) provides a primer on the SEC and state laws about unclaimed accounts. The primer also explains how mutual fund investors can protect their accounts from escheatment and reclaim their accounts once they are escheated to a state. Ultimately, investors have a lot more power than they think.