On January 28, 2019, the Financial Industry Regulatory Authority, Inc. (FINRA) launched its 529 Plan Share Class Initiative (the Initiative) to encourage member firms to self-report potential violations of rules governing 529 plan share class recommendations. The Initiative was announced in FINRA Regulatory Notice 19-04 (the Notice), which provided broker-dealer member firms with guidance concerning how and when to self-report under the Initiative, as well as the consequences for not self-reporting.1
Background on 529 Plans
529 plans are tax-advantaged municipal securities that are designed to encourage saving for the future educational expenses of a designated beneficiary. 529 plans are sponsored by states, state agencies or educational institutions, and are authorized by Section 529 of the Internal Revenue Code. One type of 529 plan, called an education savings plan, lets investors open an investment account to save for the beneficiary’s future qualified higher education expenses. Investors typically may choose among a range of investment portfolio options, such as mutual funds, exchange-traded funds and a principal-protected bank product. These portfolios also may include static fund portfolios and age-based portfolios (sometimes called target-date portfolios). Typically, education savings plans are structured as trusts, and units of the trust are typically sold in different share classes with different fee structures.2
For instance, Class A shares might impose a front-end sales charge but no annual fees, whereas Class C shares might impose no front-end sales charge but higher annual fees. Depending on the specific time horizon of the 529 plan investment (e.g., the number of years before funds will be needed to pay education expenses of the beneficiary), Class C shares may be significantly more expensive than Class A shares after all the charges are taken into account.
FINRA’s Focus on Broker-Dealers Selling 529 Plans
In prior examinations of broker-dealers, FINRA raised concerns regarding supervision of share-class recommendations to customers of 529 plans. More specifically, FINRA’s December 2017 Report on Examination Findings identified supervisory failures in connection with broker-dealers recommending investments with multiple share classes,3 and FINRA’s 2016 Regulatory and Examination Priorities Letter cited suitability issues with multi-share class investments in 529 plans.4
The Securities and Exchange Commission (SEC) launched a similar initiative in February 2018 with respect to the recommendations of mutual funds by SEC-registered investment advisers with the goal of encouraging such advisers to self-report certain violations relating to their failure to adequately disclose conflicts of interests associated with the receipt of 12b-1 fees when a lower share class was available for the same fund.5 Although the SEC’s initiative is still ongoing, SEC officials have asserted that “scores” of firms have self-reported pursuant to the initiative, and the apparent success of the SEC’s initiative may have compelled FINRA to offer a similar self-reporting opportunity for firms selling 529 plans.6
Finally, FINRA’s focus on 529 plan supervision may have been driven by the December 2017 amendments to the Internal Revenue Code expanding the use of 529 plans. Pursuant to these amendments, 529 plans can now be used to pay for certain elementary or secondary school (i.e., grades K-12) educational expenses, in addition to the higher education (i.e., college) expenses typically paid for with 529 plan investments. According to the Notice, these amendments underscored the importance for FINRA to ensure that 529 plan share class recommendations were suitable to the needs of each customer.
Who Should Consider Self-Reporting?
The Initiative is focused on broker-dealers that have inadequate supervisory systems with respect to any of the following: (1) training regarding the costs and benefits of different 529 plan share classes; (2) understanding and assessing the different costs of share classes; (3) receiving or reviewing data reflecting 529 plan share classes sold; and (4) reviewing share class information, including breakpoints or sales charge waivers, to determine the suitability of 529 plan share class recommendations.
FINRA requested that broker-dealers that self-report issues with their 529 plan share class supervision also assess the impact of such failures on customers in light of the Initiative. In assessing the impact, firms may employ either a customer-specific analysis or a statistical approach to identify customers who were recommended unsuitable 529 plan share classes given their specific investor profile.
For example, certain 529 plans may offer both Class A and Class C share classes, in which the aggregate costs of Class C shares will likely exceed the aggregate cost of Class A shares after approximately six or seven years due to the ongoing costs of Class C shares. In this case, it might be unsuitable for a broker-dealer to recommend a 529 plan investment in Class C shares if the designated beneficiary would not need access to the funds for more than seven years (e.g., future college expenses for a beneficiary younger than 12). Notably, FINRA acknowledged that it would not view a Class C share recommendation for an account with a beneficiary younger than age 12 as per se unsuitable, although the firm would have to demonstrate why the customer’s circumstances justified the more expensive Class C shares.7
In short, the broker-dealers that should consider self-reporting under the Initiative are ones that have identified certain supervisory failures in connection with 529 plan recommendations, and have the capability to assess the impact of these supervisory failures.
How to Self-Report?
If a firm has decided to self-report, it must notify FINRA in writing by April 1, 2019, in accordance with the instructions in the Notice, in order to be eligible for the Initiative. After providing this initial notice, self-reporting firms must confirm eligibility to participate in the Initiative by submitting the following information to FINRA for the period of January 2013 through June 2018 (the disclosure period):
- List of the 529 plans sold by the firm, including plan name and dates offered.
- Total aggregate principal amount invested in each 529 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 or will be implemented to enhance its supervisory obligations, including the individual supervisor responsible for implementation of any changes that have not yet been made.
- Assessment of potential customer impact caused by the 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.
The Relevant Time Period
While the disclosure period is from January 2013 through June 2018, the remediation period differs. According to footnote 16 of the Notice, “[t]he relevant time periods under any settlement, including the period for calculating any restitution, may differ from the disclosure period.” Based on conversations with FINRA staff and FINRA’s discussions with firms currently negotiating settlements, it appears that the restitution period will begin in 2008.
Consequences of Not Self-Reporting
Broker-dealers that self-report under the Initiative will receive favorable settlement terms with FINRA. According to the Notice, for any formal enforcement action brought in connection with the Initiative, FINRA’s Division of Enforcement will recommend a settlement that includes restitution for the impacted customers and a censure, but no fine.
Broker-dealers that do not self-report under the Initiative may face sanctions beyond those described in the Initiative, particularly where FINRA later identifies supervisory failures.
In addition, even if a broker-dealer self-reports, the Initiative applies only to the member firm, and does not protect individual conduct by the firm’s registered representatives regarding 529 plan recommendations.
Determining whether to self-report involves a careful assessment of the relevant facts and circumstances. Thus, each firm selling 529 plans should assess (1) the training provided to registered representatives regarding the costs and benefits of 529 plan share classes and when to recommend a particular share class; (2) how well registered representatives understand and assess the different costs of share classes when recommending 529 plans to customers; (3) how well such assessments are documented; (4) how the firm reviews data reflecting 529 plan share classes sold (e.g., through the generation and review of exception reports); and (5) how the firm reviews and handles share class information, including potential breakpoint discounts or sales charge waivers when reviewing the suitability of 529 plan recommendations. Firms should assess their 529 plan sales during the disclosure period under these criteria by the April 1, 2019, deadline.
Firms that have already been contacted by Enforcement as of January 28, 2019, are not eligible to self-report under the Initiative; however, firms that are subject to pending examinations by FINRA are eligible to report under the Initiative. Accordingly, firms currently being examined or about to be examined by FINRA for their 529 plan recommendations should carefully consider self-reporting, particularly if their sales of 529 plans during the disclosure period involve the types of supervisory failures discussed above.
Firms that decide to self-report should begin analyzing whether to conduct a customer-specific analysis or whether to take a statistical approach in determining the methodology used to calculate restitution. Given the time and resources needed to implement the desired approach and to document the rationale of the approach and why it is fair for impacted customers, firms should begin this process as soon as the decision is made to self-report.
Going forward, firms should expect to receive close regulatory scrutiny of their share class recommendations, particularly if they do not self-report and regularly sell 529 plans. Accordingly, firms might wish to assess whether their policies, procedures, tools and systems are able to properly supervise the sales of 529 plans. Among other things, firms may wish to consider: (1) enhancing the level of training provided to registered representatives regarding the recommendation of 529 plan share classes; (2) enhancing the forms completed by customers and/or utilized by registered representatives to better document the time horizon for 529 plan purchases and the rationale for the particular share class that is recommended; (3) ensuring that the necessary information regarding share classes is obtained and assessed by registered representatives; (4) providing tools for registered representatives to be able to assess which is the best share class for a particular customer; and (5) reviewing the 529 plans on their “shelf” and ensuring they are able to diligently supervise the sale of each 529 plan (and, if appropriate, reduce the number of plans available to be sold to a level that is more manageable).