US Mutual Funds Call for New Rules For “Lost” Investors

Investors of US mutual funds have long relished the benefits the investment vehicles provide: asset diversification, compounding and quick liquidity. Small investors gain the expertise of top portfolio managers, that would otherwise be available only to wealthy and institutional investors.

But what investors may not know is that their mutual funds are legally required to transfer or escheat investor accounts to state coffers if the account meets the state definition of “abandoned.” As things stand in the most aggressive states, investors could easily be designated as “lost,” when they might simply be happy with their current arrangement and have no reason to communicate with their mutual fund providers.

Unfair escheatment of mutual fund accounts is what the Investment Company Institute (ICI), the Washington DC trade group representing the mutual fund industry, wants to prevent. It is lobbying the Chicago-based Uniform Law Commission (ULC) to ensure the new version of the legislation governing transfer of unclaimed accounts to state coffers has specific rules that protect owners of mutual fund shares.

Lost Value

The reason: states might claim they try to “reunite” lost accountholders with their assets, but in reality state treasurers can liquidate escheated accounts to shore up budget gaps. In 2011 alone, the fifty states and District of Columbia nabbed a total of US$5.8 billion in so-called unclaimed property, including unclaimed accounts. Granted, investors can eventually reclaim their assets, but only as valued at the time of the transfer to state custody. Investors stand to lose plenty if the value increases during the time it takes them to discover where their account is and get their money back.

Concerns about their shareholders aside, mutual fund complexes worry they could be called on the carpet by state auditors for not escheating enough accounts, and be assessed administrative penalties. Because state treasurers are paying contingency fees to third-party collectors, these external “state auditors” have plenty of incentive to rely on the loosest possible interpretation of whether an account should have been escheated. Likewise, they could find fault with the escheatment practices of the mutual fund complex and try to force new rules on financial firms.

The new version of the Uniform Unclaimed Property Act (UUPA) won’t be out until at least 2016 and it will likely take another year for individual US states to agree to adopt it or not. Even so, there is no guarantee all of the states will embrace it at face value. When the latest version of the legislation came out in 1995, only 41 states adopted it in some version, and three states in particular — New York, Delaware, and Massachusetts — have been holdouts. Their versions of unclaimed property rules deviate the most from the national guidelines, say fund management compliance experts, in making it easier for states to take custody of investor accounts.

The ICI is trying to get a headstart in ensuring its voice is heard as early as possible in the redrafting of the UUPA now underway by the group of lawyers, judges and law professors appointed by states to represent them at the ULC . Also chiming in are trade groups representing broker-dealers and other industry segments who aren’t too happy with state treasurers and other agencies eager to get as many unclaimed accounts into their hands as possible. Given that mutual funds are held by a whopping 90 million investors, the ICI clearly has an interest in protecting the funds and their investors.

In their role as recordkeepers, mutual fund companies are responsible for opening accounts, paying out or reinvesting account revenues, and maintaining files on the shareholders whose accounts are registered in their own names. In that role, they must also monitor whether any accounts start to meet the criteria of unclaimed and make efforts to find the shareholders. If they can’t, the accounts must ultimately be transferred or escheated to either the state of the last known address of the investor or the state where the mutual fund complex is registered — typically either Maryland, Massachusetts or Delaware.

Quiet Investors at Risk

Just how mutual fund companies determine whether an investor is “lost” or not depends on the state rules — which may be the state of domicile of the fund management firm or may be the state of residence for the account holder.  While federal law requires mutual funds to use two mailings returned as “undeliverable” as the guidepost, Delaware and other states rely on a far lower “no contact” standard. In those states, unless an investor proactively contacts the mutual fund company regarding his or her account once every three years, he or she could be considered lost and the account would then be required to be turned over to the state.

Although all financial accounts are susceptible to being escheated under Delaware’s rules, mutual fund accounts could well be far more vulnerable. The reason: they are held by long-term investors, not active traders. “Just how many investors will contact a mutual fund unless they want to make a change to an account or have a question about it?” points out Tamara Salmon, senior associate general counsel for the ICI.

The increase in investors choosing to “go paperless” in fund communications only complicates the issue. According to legal experts, an investor that chooses to receives email notices, such as the availability of statements or prospectuses, and then accesses the documents online  through a password-secured website account will be seen as communicating with the fund in many states. But in others, the criteria for contact requires written communication.

What’s more, mutual fund accounts often have beneficiaries who are only identified by name and social security number. So if the account holder dies, the mutual fund company may not be able to track down the beneficiary. That leaves the door wide open for the mutual fund to be compelled to transfer the account to the state in which the mutual fund complex is incorporated.

Hired Guns

Even if mutual funds believe they have complied with state law and escheated all of their unclaimed accounts, they might still be second-guessed by external auditors hired by the states. “Given that the auditors earn a percentage of the value of the accounts escheated, it stands to reason they will do their best to prove the mutual funds are not doing their job well enough,” says Salmon.

Those auditors have already made a point of raising the bar for what financial firms have to do when it comes to tracking down lost investors and escheating their accounts, as evidenced by recent well-publicized cases affecting mega name insurers and broker-dealers. Apparently, the auditors believe a financial firm must proactively monitor the Social Security Administration’s Death Master File, and prove an account holder is alive if the file lists the holder as deceased. Otherwise, the account is considered escheatable.

Mutual fund companies are concerned that such a provision could find its way into the new version of the new uniform legislation governing unclaimed accounts. Complying with new standards not required under federal or current state laws could come at a high cost — not to mention the investor relations disaster when shareholders discover their accounts are now in the hands of the state.

So what exactly do mutual fund complexes want? At minimum, they are hoping the new legislation requires them to classify accounts as unclaimed only if two mailings sent to a shareholder are returned as undeliverable. The no-contact rule simply doesn’t work, they say. “When the states use a no-contact standard as the trigger for deciding an investor is lost, there are situations where a mutual fund company might have a valid address but is forced by state law to escheat the property,” explains Salmon.

In addition, the ICI, like other investment-related trade associations, is hoping that the new version of the legislation addresses their concerns about the aggressive tactics used by contingency-fee auditors and the inherent conflicts of interest in how states currently compensate such auditors. At the very least, the ICI wants those fees publicly disclosed and “conditions imposed” on how state auditors operate.

Ideally, the ICI is hoping, the new uniform code will enable an investor to ask that the mutual fund complex not escheat accounts considered unclaimed. Instead, the account could remain in the hands of the mutual fund complex and in the name of the shareholder, rather than being liquidated by the state with the value of the liquidation proceeds being frozen in time. Under such a scenario, the shareholder would continue to benefit from reinvested dividends, compounding and market appreciation. And when the investor decided to cash out, it would be for the value of an account that had been professionally managed until that date.

Several New York-based attorneys specializing in investment funds tell FinOps Report it’s likely state treasurers will resist any public transparency of their arrangements with third-party auditors. Likewise, given their interest in taking custody of as many investor assets as possible, they are also unlikely to support the idea of allowing investors a say in whether their accounts can be escheated or not.

The best scenario for mutual funds, they predict: the new uniform act might require accounts to be escheated only when the owner’s address is no longer valid and the mutual fund is unable to find a valid address. “Even that small concession could go a long way to reducing the number of accounts states can claim,” says one New York securities law expert.

If there are no concessions to mutual fund company concerns in the new uniform law, or if states attempt to take custody of accounts under terms that the funds or investors consider unfair, the result could be a replay of what is happening today in the insurance industry. In state after state, court battles are being waged between the insurance industry and state treasurers, as well as class action suits by beneficiaries. The cases, so far, are going both ways, but the cost is heavy for both sides.