Fund Transfer Agents: SEC Toughening the Rules

Providers of shareholder recordkeeping services for US mutual funds and non-equity accounts could soon face more regulatory oversight if the US Securities and Exchange Commission has its way.

The SEC’s lengthy concept release issued late last year suggests that the US regulatory agency wants rules to keep up with the changing times. To that end, it is seeking industry comment on how it should update its rules affecting transfer agents to include far more than those who service traditional certificated stock accounts. It also wants feedback on how all transfer agents should follow more stringent operating standards, particularly when it comes to preventing investor fraud. Comments are due by February 29.

Several equity and mutual fund transfer agents contacted by FinOps Report last week declined to comment on the SEC’s concept release on the grounds they would need far more time to digest the lengthy document. In a letter to the SEC, the Securities Transfer Association, the trade group representing 130 transfer agents in the US and Canada requested that the SEC extend its timetable for comment by an additional 60 days. “Given the number of issues raised in the release, the deadline for comments is rather short,” acknowledges Edward Pittman, special counsel at Dechert in Washington, D.C. In the 208-page concept release, the SEC is seeking feedback on 600 questions reflecting 170 separate areas of transfer agency work.

The concept release doesn’t come as a surprise to transfer agents. It follows several years of internal debate at the SEC about how to upgrade the antiquated rules affecting transfer agents adopted back in 1977. However, it was the SEC’s mounting concern about the unintended role of some transfer agents in helping microcap companies illegally lift restrictions on public trading that apparently drove the big agency into action.

“Of all of the SEC’s suggestions in its comment release, the ones involving transfer agents and privately held shares is the one they are most worried about because of the potential for liability,” cautions Anna Pinedo, a partner at Morrison & Foerster in New York. Case in point: In 2014, the SEC fined Registrar & Transfer, now owned by Computershare, $127,000 in penalties, disgorgement and interest for its alleged role in promoting microcap fraud. Its former chief executive was fined US$25,000 and banned from a supervisory role for a year.

In addition to issuing stock certificates, paying dividends and managing dividend reinvestment plans, transfer agents help shareholders change the status of accounts from restricted to public so they can eventually sell the shares. Transfer agents have long complained that without explicit regulatory rules and the resolution of contradictory guidelines from states, they could be fined for honest mistakes in removing the restrictions on the unregistered shares, which are not supposed to be sold to the public. Once that occurs, con artists could artificially drive the stock price up and them dump their shares on unwary investors until they tank.

In making recommendations about just what transfer agents should do when it comes to their role as gatekeepers for restricted securities, the SEC is also putting their feet to the fire.”Transfer agents are hoping that the SEC will provide a reasonable safe harbor, or some other guidance that defines their obligations,” says Pittman.

In its concept release, the SEC says that it will propose a new rule prohibiting a registered transfer agent or any of its officers or employees from facilitating the transfer of securities if it knows or suspects an illegal distribution of shares would occur. The SEC does not suggest any safe harbor, but seeks comment on whether it should require transfer agents wanting to remove restrictive legends from securities to first obtain an opinion letter from an attorney recommending the decision, obtain evidence of applicable registration statements or exceptions, and conduct at least minimal due diligence on the firm. The SEC also wants to know whether it should explicitly identify red flags which would require further investigation by the transfer agent.

Next Targets

Although the SEC dedicated most of its concept release to the specific procedural requirements for equity transfer agents, it didn’t neglect transfer agents for mutual funds. Those transfer agents, which can either be affiliates of the mutual fund complex or distinct third-parties, typically register with the agency, but have been exempt from following the nitty-gritty turnaround, processing, performance and recordkeeping rules affecting equity transfer agents. Boston Financial Data Services, DST and US Bancorp Fund Services are considered among the largest US mutual fund transfer agents based on the number of accounts serviced.

The reason for the SEC’s easier treatment: they serviced accounts held in dematerialized form — blips on computer screens, rather than shares held in certificated form.

That distinction, the SEC now says, is no longer valid. “Today most equity securities are either immobilized at Depository Trust Company (DTC) or completely dematerialized and issued in book-entry form, potentially making the processing of securities issued by mutual funds and equity securities issued by operating companies more alike than different, and raising the question of whether the Commission should consider reversing the exemption to SEC Rule 17ad-4,” explains the SEC in its concept release. The US is behind many overseas markets in allowing for immobilization, a process whereby investors can receive certificates upon demand with those certificates held or “immobilized” in the vaults of DTC, the US’ central securities depository.

Transfer agents of mutual funds collect payments from investors for share purchases, or make payments in the case of share redemptions; record transactions on security master files, and coordinate with mutual fund administrators to calculate net asset values. Mutual fund transfer agents are also responsible for processing commission payments for distributors– such as broker-dealers — and interacting with broker-dealers and banks who act as sub-transfer agents. Many US investors buy and sell shares of mutual funds through their broker-dealers and banks, rather than the mutual fund complex directly.

In seeking industry feedback on its concept release, the SEC asks whether mutual fund transfer agents should be subject to the same rules as equity transfer agents or different ones, because of the different nature of the assets they service and the different functions they perform. The SEC also asks, if it kept its exemptions on recordkeeping and other rules for mutual fund transfer agents, whether closed-end funds should also benefit from those exemptions. Currently, transfer agents for closed-end funds must follow all of the same operating rules as equity transfer agents.

Not only is the SEC thinking about leveling the playing field between mutual fund transfer agents and equity transfer agents, but it is also considering going a step further in having some say in the terms of the contracts between mutual fund transfer agents and sub-transfer agents.. Those contracts govern the division of labor between the two parties and the fees paid to the broker-dealers and banks.

Although the SEC is not specific about the  terms mutual transfer agents should include, it suggests that at a minimum mutual fund transfer agents should know just who their underlying beneficial investors are. Broker-dealers and banks could be required to disclose the identities of those shareholders to the transfer agents, which would otherwise be hidden behind the current “omnibus” account structure. The transfer agents only know the names of the broker-dealer and bank intermediaries through which investors buy and sell mutual fund shares. “Any shareholder transparency would be welcome by mutual fund companies who want to ensure that they receive the necessary votes for their agendas,” notes Pittman.

Also on the table for discussion is just how mutual fund transfer agents are compensated. Transfer agents for equity accounts are typically paid on the basis of an administrative fee per account, while transfer agents for mutual funds are paid based on a percentage of the value of the assets under management. The SEC is worried that the different fee structure could create a conflict of interest. “One of the themes reflected throughout the concept release is the SEC’s attempt to impose on transfer agents duties to shareholders,” says Pittman. That stance differs from the historic practice of viewing transfer agents as agents of the issuer.

Although third-party administrators (TPAs) — such as transfer agents for employee benefit plans, company direct purchase plans and retirement plans — can voluntarily register with the SEC, they don’t always follow the same rules as their equity brethren. The regulatory agency is considering whether it should new rules governing the specific activities of TPAs or require them to register as broker-dealers, which would subject them to net capital and customer protection guidelines.

The SEC does exempt transfer agents from registering as broker-dealers as long as they perform “clerical or administrative services,” but the lines of responsibility are fuzzy. Current rules don’t adequately address the functions performed by TPAs, which can resemble those done by broker-dealers and banks. Those services include making payments, processing purchase and sale orders and netting purchase and redemption orders with each other.  “Should the Commission amend the rules so that transfer agents performing specific activities are exempt from broker-dealer registration rules only (i) if they are registered with the Commission as a transfer agent (ii) limit their activities to those specified in the general rule and/or (iii) agree to abide by certain other conditions designed to protect investors and limit the risks associated with those activities,” asks the SEC.

More Ops Oversight

Legal experts believe that the SEC’s stance on how equity transfer agents handle restricted shares and on how mutual fund transfer agents and TPAs should be regulated will draw the greatest attention. However, they caution that transfer agents should also keep a watchful eye on the following activities:

Compliance: The SEC wants to know whether it should require transfer agents to designate a chief compliance officer and maintain, implement and enforce written compliance or supervisory policies and procedures. “Many transfer agents already have a chief compliance officer and program in place, but those which don’t may need to formalize the duties under a specific individual and come up with formal documentation and governance,” says Pinedo.

Transparency: Unlike their larger brethren, smaller transfer agents may not rely on written agreements with issuers and even if they do, they may not be as detailed as necessary, cautions the SEC.  The regulatory agency wants to pass a rule requiring all transfer agents at a minimum rely on contracts with issuers which include a description of the services covered and the performance metrics, responsibilities of each party, the duration of the agreement, termination fees, data protection and indemnification.

The SEC suggests that transfer agents should be required to clarify their fees and reveal their fee arrangements in filings with the SEC using a standardized framework or terminology. While such a scenario might be well-received by issuers who find it difficult to do an apples-to-apples comparison of fees among transfer agents, transfer agents could view the new disclosure as unjustifiable and anti-competitive, according to Pittman.

Data Security: Given that transfer agents have varying levels of technological sophistication and no regulatory requirements when it comes safeguarding critical information, the SEC is asking whether they should be required to create and maintain written business continuity plans, and basic procedures governing the use of information technology. Included in the program would be measures for the prevention of data breaches, IT governance and management. IT experts tell FinOps that cybersecurity audits could become the norm for all transfer agents, not just the largest ones.

Outsourcing: With outsourcing growing in popularity because of reduced labor costs, the SEC is starting to worry about how vigorously transfer agents are monitoring third-party providers and offshore sites providing information technology, data entry or customer call center support. “The current rules are not designed with outsourcing or foreign transfer agents in mind,” explains Pittman.

The SEC wants to know whether, at a minimum, it should require transfer agents to complete a written agreement with third-parties and offshore sites and whether it should subject some or all of the records associated with the performance of the agreement be subject to the SEC’s inspection. The reason: they would be considered records of the registered transfer agent. The SEC also inquires whether it should impose additional recordkeeping, processing or transfer agent rules on third-party firms, including foreign companies, hired by transfer agents.