FINRA Releases Regulatory Notice Announcing 529 Plan Share Class Initiative

Mary Donohue

Associate Editor

Loyola University Chicago School of Law, JD 2020

On January 28, 2019 the Financial Industry Regulatory Authority (FINRA) released Regulatory Notice 19-04 announcing a 529 Plan Share Class Initiative encouraging firms to self-report potential violations. Broker-Dealers are encouraged to consider self-reporting under the initiative if they have identified specified failures in connection with 529 plan recommendations, and have the ability to assess the impact of the failures. Firms have until April 1^st to notify FINRA in writing if it has decided to self-report.

Background

529 plans are tax-advantaged municipal securities designed to encourage saving for future educational expenses of designated beneficiaries. Since they are municipal securities, issued by a non-government entity, they are governed by the rules of the Municipal Securities Rulemaking Board (MSRB). MSRB Rule G-19, Suitability of Recommendations and Transactions, requires firms and brokers selling municipal securities to have a reasonable basis to believe that a recommended transaction is suitable in light of a customer’s investment profile. MSRB Rule G-27, Supervision, requires firms to establish and maintain a supervisory system reasonably designed to achieve compliance with applicable securities laws, regulations, and applicable MSRB rules

Shares of 529 plans are sold in different classes with differing fee structures. Class A shares typically impose a front end sales charge but charge lower annual fees compared to other classes. Class C shares typically have no front-end sales charge but impose higher annual fees. Cost impacts among classes varies depending on the length of time the customer holds the securities. The MSRB has explained that information known about the designated beneficiary is generally relevant in weighing the investment objectives of the customer, including any information about their age and number of years until the funds are needed to pay qualified education expenses of the beneficiary. For purposes of G-19, the MSRB has said that information regarding the beneficiary should be treated as information relating to the customer’s investment objective.

In the context of mutual funds, FINRA has repeatedly cautioned that firms must supervise recommendations to purchase higher-expense share classes, especially when an investor is seeking long-term investment, like college expenses. With regard to Class C shares, for example, FINRA has cautioned that customers should be informed of potential long-term “effect of the higher ongoing sales charges” associated with holding these shares, and that firms should “maintain written records of [such] discussions in their files.”

New Regulations

Effective in January of last year, amendments to the Internal Revenue Code under the Tax Cuts and Jobs Act, 529 plans were expanded so they could be used for tuition for grades K-12, subject to certain limitations. While 529 plan distributions were tax-free when used for qualified higher education expenses, now, up to $10,000 per year in 529 plan withdrawals would be tax-free if used for elementary or secondary educational expenses. These additional considerations underscore previous recommendations that a share class be tailored to the unique features of the customer and the importance of supervising such recommendations.

Because of the unique features of 529 plans, FINRA was concerned member firms might not be able to adequately supervise these plans. Thus, this newly released initiative is intended to encourage firms to assess supervisory system and procedures guiding recommendations for share-classes, identify and remediate defects, and compensate investors harmed by supervisory failures.

Self-Reporting

Broker-dealers are encouraged to consider self-reporting under the initiative if they have identified certain supervisory failures in connection with 529 plan recommendations, and have the capability to assess the impact of these failures. If a firm has decided to self-report it has to notify FINRA in writing by April 1, 2019 to be eligible for the initiative. After filing this notice, they must confirm eligibility to participate by submitting the following information to FINRA for the period of January 2013-2018:

• List of the 529 plans sold by the firm, including plan name and dates offered;
• Total aggregate principal amount invested in each plan sold;
• Description of the firm’s supervisory systems and procedures relating to 529 plan sales;
• Description of the changes to the firm’s supervisory systems and procedures that have been implemented the enhance its supervisory obligations, including individual supervisor responsible for implementation of any changes that have not been made;
• Assessment of potential customer impact caused by supervisory deficiencies, including a description of the firm’s methodology for assessing customer impact and the firm’s proposed restitution payments to harmed customers;
• Any other information the firm believes would assist FINRA in understanding the firm’s supervisory systems, suitability determinations, or assessment of customer’s investment horizon regarding share class recommendations.

Outlook

The April 1^st deadline is quickly approaching, and firms should not underestimate the possibility that a diligent internal review and self-report could result in only an informal cautionary action letter or full declination, rather than formal enforcement action. In a video interview accompanying the announcement, FINRA’s enforcement chief alluded to earlier no-fine settlements involving other supervisions where firms had self-reported, remediated, paid restitution, and cooperated. Firms should take this as a signal to diligently monitor their supervisory systems and procedures related to the sale of 529 plans, and ensure compliance with the new tax code as it relates to helping customers select plans.