Want to Price Shares Late: Get the Post Office to Help Out

US mutual fund complexes are supposed to give investors who buy and sell shares the price of the shares on the day they receive their orders.

So says the US Investment Company Act of 1940.

But insurance giant Nationwide Insurance found a creative way of not doing so. It didn’t have to rely on technology, but simply the trusty US Post Office. For almost 16 years it got the mail delivered to its building late — after the 4PM deadline on the day it was received.

Nationwide was eventually caught by the US Securities and Exchange Commission and must pay US$8 million for violating pricing rules for mutual funds. By deliberately delaying the receipt of orders involving variable annuity contracts and life insurance policies, it failed to price them in a timely fashion, says the US regulatory agency.

The underlying mutual funds in variable annuity and variable life insurance policies are only available through separate accounts offered by insurance companies. Hence, they must follow the same rules as mutual funds; Rule 22c-1 of the Investment Company Act applies. In practice,  mutual fund companies have agreed that orders received before 4PM must be priced at that day’s price, and those received after 4PM priced at the next day’s price. Nationwide’s prospectus for the variable contracts said it would do as much, but indicated in that “orders received” would depend on when the mail would arrive at its Columbus, Ohio headquarters.

No one disputes the facts of what Nationwide did, although Nationwide neither admits nor denies wrongdoing. From October 1995 to September 2011, it instructed the post office in its headquarters city of Columbus, Ohio, to sort mail that arrived for a particular box and separate any mail addressed to Nationwide Financial business which included the variable contract mail. This mail was stored separately with the understanding that Nationwide would not pick it up until after 4PM, despite the fact that first-class mail was generally ready for pick-up in the morning and there were several earlier mail collections by Nationwide or its couriers during the day. Even if that separate batch of variable contract mail was picked up earlier in the day, it was not to enter the Nationwide premises before 4PM.

Notably the exception to this practice was mail that was sent via postal Priority or Priority Plus, which provided time-of-delivery tracking to the sender. This mail was collected from the post office as early as it was available, and those orders were processed the same day.

Given this history, the SEC’s penalty for only one violation of the Investment Company Act of 1940 leaves compliance and operations specialists scratching their heads. Among the most glaring unanswered questions are: Why would Nationwide risk its reputation and a potential fine for violating SEC rules; why did the wrongdoing go on for almost 16 years; and how was it discovered? Just as curious is why the SEC didn’t cite Nationwide Insurance for other violations of the Investment Company Act such as not handling compliance requirements correctly or committing what the agency says is a wrongdoing indirectly — as in using the US Post Office to do so. Last but not least, why didn’t the SEC catch this earlier?

The SEC is well-known for slamming mutual fund companies for not following the Investment Company Act to a T, but it has taken a more mild-mannered approach to Nationwide. The settlement may be filled with details on what Nationwide did, but no explanation of exactly which department of Nationwide was to blame. Likewise there is no information about why the problem wasn’t corrected by Nationwide until 2011, or why it was corrected in 2011?l

Kid Gloves

From the way the settlement was written, Nationwide might as well have made only a technical processing error. “Apparently, the SEC was not able to prove that there was any intent to harm investors and benefit Nationwide financially,” suggests Gary Swiman, director of regulatory compliance for accountancy Eisner Amper in New York and a former fund management compliance director.

Nationwide may not have made any big bucks from its decision, but it certainly could have benefited operationally. “It could have managed its operational workload better by not processing too many orders on a particular day,” adds Swiman. That conjecture was shared by three other compliance specialists at US fund management shops contacted by FinOps Report.

Why? “Insurance companies are notorious for being short-staffed and it could be they couldn’t handle the tasks before end of day,” says one. “It must have made at least operational sense to them. The policy was written into its compliance rulebook. Its compliance, operations, and internal audit departments must have all agreed on the policy.”

What about the investors receiving a delayed price for their shares? Isn’t that being harmed? Not exactly, say an operations specialists, who point out that the consistent application of the policy didn’t favor one price movement over another. Swiman agrees. “Investors might have been harmed if they sold shares at a lower price because the NAV for the mutual fund dropped the following day. But those same investors might have benefited when they bought the shares at a lower price as well,” he points out. “Investors might have even benefited if they sold the shares at a higher price the following day. Therefore, it all becomes somewhat of a wash.”

Nationwide did have another option. That was to receive the mail after 4PM and process the orders the next morning with the previous day’s NAV, according to Nick Prokos, a partner with regulatory compliance consultancy ACA Compliance Group in Boca Raton, Fla. No one will know whether it considered that alternative, but if it did it would have realized the operational challenge, he explains. The reason: investors would not have been affected, but Nationwide would have had to do some hefty reconciliation work in figuring out how to make the underlying mutual funds whole. “In the end, it would have been far more operational stress involved than simply receiving the mail late and using the next day’s NAV,” says Prokos.

Legal Wiggle Room

Surprisingly, there is a kind of legal rationale for Nationwide’s conduct based on what the SEC itself has said or not said. In 1994 the SEC’s Office of Insurance Products, a unit of the Division of Investment Management, suggested in a guidance notice that insurance companies can delay processing an order received from a broker for up to four to five days, say legal experts specializing in the insurance industry. Likewise, in 2003 when proposing a rule change which never came to pass, the SEC said that investors who mail their purchase or sale orders to mutual fund companies are not concerned about the timing of the execution of those orders. Last but not least, the SEC has never explicitly explained just when an investment fund complex firm is supposed to pick up its mail or what is meant by “orders received.” Such a shortcoming could have given Nationwide some room for loose interpretation of its responsibilities.

Bottom line: what on the surface could appear to be egregious conduct by Nationwide might not be as egregious in the end. Nationwide could have thought it was doing nothing wrong, though the same-day handling of USPS Priority mail does suggest that Nationwide may have been hiding the intentional delay of mail pick-up from investors.

What should insurance and mutual fund companies learn from Nationwide’s settlement? It depends on just whom you ask. “There may have been room for debate about the handling of orders received through the mail, rather than over the phone or electronically, as to what to do when an order is received through the mail rather than over the phone or electronically,” says one compliance expert at a fund management shop. “The SEC may have used the Nationwide case to clarify rather muddled guidance,”

Yet another says that mutual fund complexes should take the hint about using liberal interpretation of SEC guidance. “When in doubt, check with legal counsel and the as SEC well, rather than risk operating at the edge of the law,” he says.

What do operations specialists think? “Never cut corners when it comes to complying with the rules. We’ll never know for certain whether it was matter of Nationwide simply misinterpreting the SEC’s stance on just what is meant by receiving orders, or whether it bent the rules to save on staffing costs,” says an operations director at a US mutual fund company.”If it was a matter of operational efficiency, the $8 million fine certainly changes the equation.”