Taylor Bandy – On January 28, 2019, the Financial Industry Regulatory Authority (“FINRA”) issued Regulatory Notice 19-04 (“Regulatory Notice”) which encourages broker-dealers to self-report violations of FINRA Rules surrounding 529 savings plans (“529 plans”) recommendations. The 529 Plan Share Class Initiative (the “Initiative”) is aimed at increasing compliance with FINRA rules relating to supervision and the suitability of recommendations. FINRA hopes brokerage firms will take advantage of the initiative, as FINRA’s Department of Enforcement will recommend settlements that are favorable to broker-dealers who self-report violations. According to the Regulatory Notice, the recommended settlements will include “restitution for the impact on affected customers, and a censure, but no fine.” Firms that wish to self-report must provide written notification to FINRA by April 1, 2019.
A 529 plan is a municipal security that offers tax incentives to promote saving for educational expenses. An education savings plan is a 529 plan that allows individuals to open an investment account where in the future the account’s beneficiary can use account proceeds for college expenses such as tuition, mandatory fees, and housing costs. A 529 plan’s portfolio is often invested in various mutual funds and exchange-traded fund portfolios. The age of the beneficiary and the kind of education the account is being established to fund are factors that affect the investment products and risk tolerance of the account holder.
The Municipal Securities Rulemaking Board (“MSRB”) oversees the sales of 529 plans. In FINRA’s Regulatory Notice, FINRA discusses MSRB’s Rule G-19, which imposes a suitability requirement on brokers to have a “reasonable basis to believe that a recommended transaction . . . is suitable for the customer, based on information obtained through the reasonable diligence of the broker . . . to ascertain the customer’s investment profile.” Further, MSRB Rule G-27 establishes an obligation for broker-dealers to “establish and maintain” a supervisory system to “achieve compliance with applicable securities laws and regulations.”
Unfortunately, far too often firms fail to implement supervisory procedures. As a result of a firm’s failure to supervise, investors often suffer substantial financial harm. Therefore, FINRA’s Initiative is a novel approach by FINRA to encourage firms to report supervisory lapses in order to compensate investors who were harmed as quickly as possible. In the Regulatory Notice, FINRA identified specific areas where the firm might have failed to:
“(1) provide training regarding the costs and benefits of different 529 plan share classes;
(2) understand and assess the different costs of share classes for individual transactions;
(3) receive or review data reflecting 529 plan share classes sold; and
(4) review share-class information, including potential breakpoint discounts or sales charge waivers, when reviewing the suitability of 529 plan recommendations.”
The Initiative is a great step to increase protection of retail investors from broker misconduct, but it seems unlikely that brokerage firms will self-report a defect in supervisory procedures. First, the brokerage firms must complete several steps in self-reporting to achieve a favorable settlement recommendation. FINRA wants firms to voluntarily report the impact that the lack of supervision had on customers. FINRA discusses two ways firms can self-report the impact: by reviewing whether recommendation was suitable by evaluating customer investment objectives and by a using a “statistical approach to identify categories of 529 plan customers invested in share classes that are not economically advantageous if held for the accounts’ expected investment horizon.” As noted by Sidley, firms that participated in the SEC’s Share Class Selection Disclosure Initiative had to collect “challenging and burdensome” data to meet the initiative’s requirements. In addition, Sidley noted that suitability determinations are often timely and fact-specific.
Moreover, self-reporting a lack of supervisory procedures on 529 plans will draw brokerage firms into FINRA’s spotlight. In 2018, 4,325 FINRA arbitration cases were filed and 3,756 cases were closed. Accordingly, 1,935 FINRA arbitrations included a failure to supervise claim and 1,779 included a suitability claim in 2018. It is likely that a firm that has disregarded supervisory procedures for a certain security will have other material supervisory failures. Therefore, brokerage firms will probably be hesitant to self-report a lack of supervisory procedures. Instead, brokerage firms will allow individual investors to file claims of unsuitable recommendations and a lack of supervisory procedures. Now, with less than a month left for firms to self-report, it will be interesting to see if firms accept responsibility for supervisory failures related to 529 plans.
