First published in the Summer 2017 edition of Keanotes
While securities have long been a hot spot for unclaimed property issues, the past several years have seen a continued expansion of audit activity targeting broker-dealers, stock issuers, transfer agents, mutual funds, banks, and others in the financial services industry. Unclaimed property laws—and unclaimed property audits—can present a number of specific challenges in this space. In this article, we highlight five of the key issues.
Not all financial institutions of course, will become the subject of a third-party unclaimed property audit. From a risk mitigation standpoint, however, all institutions holding customer funds or securities should make sure they are comfortable with their current programs for escheating unclaimed property to the states to which it may be reportable. There are many good reasons supporting a pro-active, risk mitigation position, including the fact that a failure to mitigate risk in advance will typically lead to a protracted, multi-year audit. A bit of advance planning, including considering the issues below, is likely to result in a smoother audit if one is conducted, and an overall better experience for customers of the financial institution.
1. Who is the Holder?
A particular challenge can be identifying the appropriate “holder” of property—i.e., the entity with unclaimed property compliance obligations—in an industry that often involves chains of contractual and custodial arrangements between intermediaries, including introducing broker-dealers, clearing broker-dealers, omnibus account holders, administrators, transfer agents, mutual funds, and others. Contractual arrangements between broker-dealers and various third parties may give rise to questions about which entity is the “holder” of unclaimed property; whether the corresponding legal liability may be shifted by contract; and whether multiple parties could ever be considered the holder for different purposes and/or different contracts.
These multiparty relationships are recognized in and governed by federal securities laws and the U.S. Securities and Exchange Commission (SEC). SEC regulations and Financial Industry Regulatory Authority Inc. (FINRA) rules impose specific requirements on customer accounts: how they are established, how they are maintained, the records that have to be created for them, and how long those records must be kept. Only specific types of broker-dealers are permitted to hold customer funds and securities, and certain broker-dealers are subject to account statement rules and possession and control requirements. In addition, SEC Rule 17Ad-17 requires broker-dealers that have customer security accounts to search for lost security holders in specified ways and at specified times.
Unclaimed property auditors and the states they represent, however, are often not focused on the federal securities laws requirements and instead see their primary mission as identifying as much money as possible to bring into the states’ unclaimed property funds (and increase the contingent auditor fees paid). Broker-dealers that believe they are not “holders” under state unclaimed property statutes and rules need to discuss their reasoning with third-party auditors at the beginning of any unclaimed property audit. Broker-dealers that believe they are holders need to consider whether there are any federal preemption issues associated with the different asset types subject to their possession and control.
2. Identifying the Appropriate Dormancy Trigger
The legal landscape across states is a patchwork of laws and regulations establishing the trigger for the running of the dormancy period. Although there are nuances across states, most states have dormancy standards for securities that run either (a) based on the owner’s last activity on the account or linked account (the “non-activity standard”), or (b) after a certain number of pieces of returned mail (the “returned-mail standard”). The non-uniformity in state law can make it challenging for broker-dealers, transfer agents, and others to apply the correct standard across all jurisdictions. As a practical matter, the non-activity standard can result in a much shorter dormancy period on an account where the owner is maintaining a buy-and-hold position without regular activity in the account, and even where the owner is still receiving mail. An ongoing concern for the industry is that application of the non-activity standard may upset investor expectations where an investor is holding a position for the long term.
This dormancy trigger for securities and brokerage accounts was a matter of extensive debate in the process to create the 2016 Uniform Unclaimed Property Act (2016 Uniform Act). The 2016 Uniform Act is a revised model law promulgated by the Uniform Law Commission (ULC) after a multi-year process of comment and hearings. Stakeholders provided significant comment on the question of whether escheat obligations for securities should be triggered by mere account inactivity (advocated by some states) or should be based on returned mail (advocated by the securities industry). The securities industry argued that escheat based solely on inactivity was in tension with federal securities laws and contrary to buy-and-hold investment strategies.
Ultimately, the 2016 Uniform Act provides generally that a security is presumed abandoned three years after a second piece of returned first-class mail. Special rules apply in the case of holders that use electronic mail, rather than the U.S. mail, to communicate with owners. In these cases, the holder must send an email to the owner not later than two years after the owner’s last “indication of interest” in the security; the holder must follow up promptly by U.S. mail if the owner does not respond to the holder’s email within 30 days. If that mailing is returned as undeliverable, the security is presumed abandoned three years after the date the mail is returned. The 2016 Uniform Act is not law but is being considered as legislation in a number of states (with partial adoption thus far in three states).
3. Handling Special Account Types
Another issue for broker-dealers and other financial institutions is dealing with unclaimed property issues for special account types that are not freely payable or distributable, such as individual retirement accounts and other tax-deferred accounts. Once again, the dormancy standards are non-uniform. For individual retirement accounts (IRAs), most states provide that the dormancy period begins to run at the time distribution is required to begin under federal tax laws, i.e. age 70½. A few states, however, count dormancy backwards from age 70 ½–i.e., as of age 70½, the account is presumed abandoned if there has been no activity in the past 3–5 years. Pennsylvania enacted in 2016 a statute that purports to apply an inactivity standard that could greatly accelerate escheat of IRAs in some situations, though the application of the statute is currently under reconsideration by the administrator.
For other special account types, however, state laws are often silent. Only a few states have specific provisions covering Roth IRAs. Health savings accounts and 529 Plans are also not expressly addressed by most state laws. These accounts types are included in a new provision of the 2016 Uniform Act for “other tax deferred accounts,” which sets a dormancy period of three years following required distributions or 30 years from account opening. It remains to be seen how many states will incorporate similar provisions into their laws going forward. Another common issue is how to apply dormancy standards to broker-dealer customer accounts that may contain an aggregation of different types of assets.
4. Audits and Use of the Death Master File
Following on the heels of multi million-dollar unclaimed property settlements involving life insurers, some unclaimed property auditors shifted focus to broker-dealers. Broker-dealer firms, including insurance-affiliated broker-dealers, have been a target of multistate unclaimed property audits in recent years. As with life insurer audits, some unclaimed property auditors are using the Social Security Death Master File (“DMF”) as an audit tool with broker-dealers. The auditors use the DMF to identify account holders who may be deceased and thereby identify accounts supposedly overdue to the states as unclaimed property and/or to trigger or accelerate dormancy for IRAs. This technique has been controversial in unclaimed property audits, but shows no signs of abatement.
The auditors are also continuing to target stock issuers and transfer agents. Some auditors have used the DMF as a primary tool, whereas other auditors focus on non-activity standards and look for dormant accounts under more traditional means. Auditors may attempt to apply a rigorous standard for what constitutes owner-generated activity for purposes of resetting the dormancy period.
5. States’ Liquidation of Securities
Another ongoing concern is what happens to an investor’s position after it has been escheated to a state. If a state liquidates a security and the security then appreciates in value, the owner may lose the benefit of his or her investment. This can create potential risk for a holder who has escheated securities to a state, and state laws and practices vary on the length of time a state will continue to hold a security before liquidating it. The 2016 Uniform Act provides that the state must wait at least three years before liquidating a security, and also allows the owner to recover full market value (or replacement of the security) for up to six years. By contrast, under newly enacted Delaware law, the state may sell an escheated security as soon as practicable after providing notice to the owner. South Dakota also recently passed legislation accelerating the period for liquidating escheated securities, which will now be sold within 90 days.
In negotiating resolution of an unclaimed property audit, the holder should take care to protect itself against any claim that it negligently transferred securities to a state, which may liquidate the securities to the financial detriment of the shareholder.
Unclaimed property continues to present a challenging compliance environment for financial services companies. This is particularly true in the securities industry because of the interrelationship and tensions between state unclaimed property laws and federal securities laws. Diligence in mitigation, compliance and reporting can lessen the burdens of a potential audit in this area.