By Merrill B. Stone & Stephanie W. Estey
We all can be a little forgetful. For example, most of us who wear glasses seem to misplace them with an annoying degree of regularity. We tear up the house, going from room to room only to find them, quite literally, right in front of our noses. And how many of us care to admit how many times we have had to dial our cell phones from a landline so we can locate where we left it! Yes, these are inconveniences. But, in the scheme of things, these aren’t that big of a deal; mistakes that can be easily rectified. Unfortunately, this isn’t the case for everything – and, it’s especially not the case where shareholder records are involved. In this article, we hope to raise awareness of the need to take great care in maintaining and protecting shareholder records and to provide a few helpful hints to avoid problems. This is an area in which both issuers and transfer agents should take notice.
A Few “Horror Stories”
Fortunately, situations that garner widespread publicity in which companies have run into trouble for not keeping good shareholder records appear to be relatively infrequent. However, it only takes a few real life “horror stories” to show us how serious and unexpected problems can be when the records aren’t quite accurate or there at all.
One New York case that helps make the point is Federal Insurance Company. v. Walker. There, Mrs. Walker transferred shares she held in a company, but the company and its transfer agent failed to register the transfer and she continued to receive dividends. Later, when her son (who was unaware of the transfer) unsuccessfully tried to locate the certificates, he convinced her to contact the transfer agent and sign indemnification agreements (which her son guaranteed) to obtain a bond so that new certificates could be issued. The shares were sold (again) after they received the new certificates. After Mrs. Walker passed away, the transfer agent discovered the failure to record the first transfer and cancel the original certificates and asserted claims against her estate and the insurance company that issued the bond, including for return of the dividends that were wrongly paid over the course of several years. Litigation then erupted, including having Mrs. Walker’s son and her estate asserting claims against the issuer of the stock and the transfer agent for negligence. The New York Court of Appeals (which is the state’s highest court) held that the claims against the transfer agent and the issuer could not be dismissed and that the matter had to go to trial.
This is an area in which both issuers and transfer agents should take notice.
A few years ago, a New York federal court case involved years of expensive litigation that could have been avoided if someone had been diligent enough to double-check the shareholder records. In this case, the plaintiffs (investors in several mutual funds), brought a class action alleging securities fraud against Citigroup and certain of its subsidiaries. The lead plaintiff certified that it had purchased more than 75,000 shares of a particular mutual fund and had an “average dollar holding” of $8,395,128 during the class period. After an exhaustive litigation which included extensive motion practice, an appeal to the Second Circuit, a remand, more motion practice and discovery, the Court received notice of a “seismic” factual error six years to the day after the initial lawsuit was filed, informing it that “Lead Plaintiff [had] never purchased any of the securities at issue in this action.” The Court stated:
While it is tempting to attribute this mistake to a mere scrivener’s error (as Lead Counsel suggests), that explanation is wholly inadequate…Lead Counsel is well aware of the costs associated with such litigation and should have conducted sufficient due diligence before embarking on this six-year detour and frolic. Standing to bring claims on behalf of a class is a threshold question that must be evaluated before a complaint is filed. And this responsibility continues throughout the litigation. With a little diligence, Lead-Counsel should have unearthed this important fact during motions for appointment of a lead plaintiff and motions challenging standing.
There’s also always the classic fraud. In another federal court case, the CEO and General Counsel and CFO of a public company allegedly perpetrated a scheme in which over a three year period unrestricted shares were fraudulently issued under a stock option plan well in excess of the number of shares that were authorized under the plan and to ineligible recipients. After the scheme was discovered, a class action was initiated against the company, and the company eventually filed for bankruptcy. The trustee in bankruptcy sued the company’s transfer agent, alleging that by permitting the scheme to be perpetrated, the transfer agent was liable for fraud, negligence and breach of contract. The contract between the company and the transfer agent contained fairly standard exculpation provisions that essentially eliminated the transfer agent’s liability to gross negligence and willful misconduct and provisions that entitled the transfer agent to rely on certain documents. The court dismissed all claims against the transfer agent, leaving the company without recourse.
These “horror stories” are cautionary tales that demonstrate the need for issuers and transfer agents to do what they can to protect themselves from problems resulting from not properly maintaining shareholder records.
In another case involving fraud, a company’s employee – who was also acting as the in-house transfer agent – nefariously manufactured a fake claim of lost securities from the Depository Trust Company (“DTC”). Unchecked, the employee was able to waive the indemnity bond and replaced the so-called “missing” shares in the name of an entity that he controlled. Subsequently, the employee sold the shares in the entity’s name, reserving some of the proceeds to “issue a check to DTC each quarter to cover the stolen shares - that were, of course, in DTC’s vault all along.” The fraud, however, didn’t come to light until ten years after the fact, when the issuer merged and the DTC came up “short” – $80 million dollars’ worth of shares. Here, as above, the importance of properly managing shareholder records is underlined, as well as the best practice of ensuring that the appropriate checks and balances are in place.
These “horror stories” are cautionary tales that demonstrate the need for issuers and transfer agents to do what they can to protect themselves from problems resulting from not properly maintaining shareholder records. While there are important legal requirements that an issuer – or transfer agent – must adhere to, there are also industry best practices that can be applied to help mitigate risk.
The Legal Requirements
The first thing a company needs to do is look at the corporate laws of the state in which it is formed. These statutes typically contain certain requirements regarding shareholder record retention. For example, the Delaware General Corporation Law requires Delaware corporations, among other things, to (a) maintain and make available before a stockholder meeting a complete list of stockholders entitled to vote and (b) for most publicly traded companies, appoint an inspector of elections who must ascertain the number of shares outstanding and the voting power of each. Under the New York Business Corporation Law, in addition to other duties a New York corporation must (a) keep correct and complete books and records, including, at the office of the corporation or of its transfer agent or registrar in New York, a record containing the names and addresses of all shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record thereof and (b) if publicly traded, generally appoint an inspector of elections who must determine the number of shares outstanding and the voting power of each.
Article 8 of the Uniform Commercial Code (“U.C.C.”) sets forth other duties of issuers of securities. Under Article 8, essentially the transfer agent has the same obligations as the issuer to an owner of a security. These obligations include the duty to register transfers of securities that are presented in good order. Simply put, if a shareholder sells shares, then the issuer (and the transfer agent) must not only register the transfer, but must also update the company’s books and records to reflect the change.
On the other hand, under the U.C.C. an issuer and transfer agent can be liable if they permit a transfer that was somehow “wrongful”. Some instances of such “wrongful transfers” that happen with alarming frequency include forged transfer instruments, incomplete or obsolete paperwork (i.e., missing records that a stock has indeed been transferred) or the failure to obtain a legal opinion or other appropriate documentation when restricted securities are presented for transfer. The Official Comment to the U.C.C. makes it clear that the issuer and transfer agent could be liable even if there was “no reason to suspect that the endorsement was forged” or if the issuer or transfer agent “obtained [all] the ordinary assurances”. Consequently, if an issuer or transfer agent was duped, even if it did everything as properly as possible, it could still be responsible. The U.C.C. does permit the issuer and transfer agent to obtain “reasonable assurance” that an instruction or endorsement is genuine and authorized (which typically involves a signature guaranty and, depending on the circumstances, other documents), but this does not really solve the problem entirely.
… if an issuer or transfer agent was duped, even if it did everything as properly as possible, it could still be responsible.
There are contexts other than routine transfers of securities where significant problems can arise if shareholder records are not in good order. For example, each state has unclaimed or abandoned property laws that require unclaimed property (including securities and uncashed dividend checks) to be reported and escheated after a designated number of years. In recent years, many states have become quite aggressive in enforcing these statutes, including retaining private companies to “audit compliance” with unclaimed property laws, often catching issuers and transfer agents by surprise. Also, in “corporate reorganization” transactions, such as mergers and tender offers, it is virtually impossible to obtain a 100% shareholder response. In such cases, it is not unusual for a shareholder to come “out of the woodwork” and assert a claim years after the transaction closed. These are just a few of the reasons why it is necessary to preserve shareholder records that prove who the rightful owner of the shares is.
Transfer agents, which are required to register with the Securities and Exchange Commission (“SEC”) under Section 17A of the Securities Exchange Act of 1934, as amended, must also comply with SEC regulations. In addition to other duties, the SEC rules contain specific requirements for (a) the record keeping transfer agent to maintain a master securityholder file listing each securityholder account, post within certain specified time periods transfers and redemptions of securities and “exercise diligent and continuous attention” to resolve any discrepancies, (b) every registered transfer agent to keep records of items presented for transfer for two years, documentation regarding the total issued and outstanding securities so long as and for one year after the transfer agent acts in that capacity for the particular securities and retain cancelled certificates for six years and (c) transfer agents to comply with certain search and diligence requirements with respect to lost security holders. We must emphasize that the SEC regulations merely establish minimum requirements. They do not, however, provide much comfort if a claim is asserted long after the required record keeping period has elapsed.
What Can You Do To Avoid Problems?
While it is, of course, important to comply with applicable legal requirements, as the cases discussed above demonstrate, merely doing what the law strictly mandates does not necessarily eliminate problems or liability. Even if a company “dots all of the I’s” and “crosses all of the T’s” set forth in the relevant statues and regulations, there is still the potential for significant exposure and expense. With that in mind, here are some measures to consider if a company or a transfer agent wished to implement what we view are “best practices”:
Although we live in a day and age where companies seek to cut costs, this is an area where being “penny wise” can really make a company “pound foolish”. Thus, we typically encourage even some of our smaller and more cost conscious issuer clients to go out and hire a professional transfer agent to help with shareholder records. We believe that hiring an agent that is well versed in what is required and what the best industry practices are in the long run will save money and enable management to focus its attention on its core business rather than trying to keep up with the various and often esoteric rules and requirements.
When selecting a transfer agent, a company should make sure that it is comfortable that it is sufficiently sophisticated and has sufficient procedures and controls in place to avoid problems, and, if something goes wrong, has the financial wherewithal and insurance to weather the storm. While history has shown us that even the largest and most experienced transfer agents are not necessarily immune from fraud and occasional lapses, we believe that a company’s chances for enjoying smooth sailing are significantly enhanced by choosing what it concludes is the best provider rather than the low cost one.
In order to be prepared to address issues that might well arise many years after the fact, we recommend that certain records be retained in perpetuity. These include the shareholder register, the control book, daily transfer journals and, to the extent possible, associated “back up” documents (e.g., signature guaranties, affidavits of loss, stolen or mutilated securities, indemnity bonds, instruction letters, legal opinions relating to original issuances or transfers). Again, the cases we discussed show clearly that in a number of contexts, disputes and litigations can be initiated well after any legally required records retention period has expired.
Obtain and keep in effect insurance to cover any potential losses, in case all else fails.
To sum up, this is an area in which the time and resources devoted to prevention might well turn out to be far less than what is involved in a cure.
Mr. Stone is a Partner and Ms. Estey is an associate at Kelley Drye & Warren LLP. Kelley Drye is an international law firm comprised of approximately 300 attorneys with offices in New York, Washington, D.C., Los Angeles, Chicago, Stamford, Connecticut, Parsippany, New Jersey and Brussels and an affiliated office in Mumbai.
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