Finra is primed to start flexing its muscles against broker-dealers that allow their advisers to sell high-cost college savings plans. But rather than plowing ahead with penalties, the regulator is offering clemency to encourage reform. Will firms bite?
The Financial Industry Regulatory Authority Inc. finds brokerage firms aren't doing enough to reasonably supervise the share classes their brokers recommend in 529 plans. The agency launched an initiative Jan. 28 that allows firms to self-report potential supervisory and suitability violations related to such recommendations. If firms can successfully address problems and deliver a plan to return money swiftly to harmed customers, Finra's department of enforcement will recommend a settlement that doesn't include a fine. If a firm doesn't self-report, it would not be eligible for an automatic fee waiver if the agency later finds a violation.
It's a new direction for Finra, according to Susan Light, partner at law firm Katten Muchin Rosenman and former Finra senior vice president and chief counsel for enforcement. Though the agency has always required that brokerage firms self-report violations, never before has it said it will waive fines in exchange for cooperation and reimbursing investors.
"If I owned a brokerage firm, whether I had five brokers or 5,000, I would be looking under my tent to see if I sold 529s — Did I pay attention to share classes? What is my exposure, and what are my supervisory procedures?" Ms. Light said. "I think it would be foolhardy for any brokerage firm that sold 529s to not do their own self-assessment."
Despite the incentive, it remains to be seen how many firms will actually follow through and self-report.
No small task for firms
Tracking down all the information needed to calculate restitution for customers is no small task. Few have the capabilities in-house to get it done, and many firms haven't retained the necessary transaction details in their own systems, said Alex Russell, managing director of securities litigation and regulatory enforcement for consulting firm Bates Group.
"Getting the data together and getting it into a shape where you can analyze it is actually very complicated," he said.
The clock is already ticking. Finra initially gave broker-dealers until April 1 to inform the enforcement division of plans to participate, and until May 3 to submit the required information to remedy the matter.
"Finra has left very little time to get your hands around the subject," Mr. Russell said. "It's too early in the game to know how many firms are going to end up self-reporting, or what the level of restitution is going to be."
The regulator must have heard such complaints about the deadline, as it announced last week it would give firms until April 30 to announce plans to participate, and until May 31 to submit information.
Finra hopes firms recognize the self-reporting initiative as an opportunity to identify and improve their supervisory practices around 529 plan share classes. It's now up to firms to take action — or roll the dice with their existing programs.
Susan Schroeder, Finra executive vice president and head of enforcement, said the 529 Plan Share Class Initiative emphasizes some of the cornerstones of Finra's new streamlined approach to enforcement: improving compliance while getting money back to harmed customers more quickly.
"The idea of a no-fine settlement based on a firm's self-reporting and then working closely with Finra to remediate and pay restitution, that's consistent with our current cooperation policy," Ms. Schroeder told InvestmentNews.
A 529 plan is a municipal security investors can use to save money tax-free for a beneficiary's future education expenses. Only a small percentage of families take advantage of 529 plans, but usage has grown since 529s were introduced in 1996 as part of the Small Business Job Protection Act. Nearly 14 million accounts invested $311 billion in assets in 529 savings and prepaid plans during the fourth quarter of 2018, according to data from Strategic Insight.
Plans are commonly sold as Class A shares, which have a front-end sales charge but lower annual fees, or as Class C shares with higher annual fees without front-end sales charges. For customers with more than seven years to invest in the plan — a college fund set up for a young child, for example — the aggregate cost of a C share exceeds that of an A share.
The problem is some advisers don't recommend the share class that would be most cost-effective for investors.
"Let's be honest, 20 years ago you saw a lot of situations where people would either use an A share to jam somebody in and get that big upfront commission, or use a C share because it was someone who is going to invest for a long period of time and pay the 1% [annual fee] forever and ever," said Brock Jolly, founder of The College Funding Coach.
But even advisers with the best intentions can slip up.
"The reality is that advisers are spread pretty thin at times," Mr. Jolly said. "You're just trying to get something processed. Maybe there's an element of laziness, but a lot of times people aren't paying attention to details."
Finra has been concerned about share class suitability violations for a long time, Ms. Light said. The issue has made it into exam priorities in the past and the regulator has brought charges against firms.
So why bring the focus to 529 plans in particular in 2019? For starters, the new tax code stemming from the 2017 tax reform law opened up 529 plans to more than just college tuition. Now investors can use them for K-12 expenses, complicating the issue of share class suitability based on the length of time the money will be invested.
Another catalyst for Finra's new effort is the success of a similar initiative by the Securities and Exchange Commission in early 2018. That program allowed self-reporting by investment advisers who had improperly invested clients in high-fee mutual funds share classes. According to Mr. Russell, who helped more than a dozen firms participate in the SEC program, Finra is essentially modelling its program after the SEC's.
Qualitative vs. Quantitative
Ms. Schroeder said the primary difference with her agency's program is that it is a qualitative assessment of supervisory structures and share class suitability rather than a purely quantitative look at fees.
In other words, Finra isn't saying Class C shares are always bad. It wants firms to ensure investors are getting the right investment to fit their needs. In particular, Finra wants to see improvements in how brokers are trained on the costs and benefits of different 529 plan share classes, how firms receive data on plans sold, and how firms review the suitability of recommendations.
Though many broker-dealers welcome the opportunity to improve supervisory systems and procedures, firms are less pleased with the initiative's disclosure requirements, Mr. Russell said. Firms need to look for violations dating back to 2013, and go back to 2008 to calculate restitution for investors.
"So you can imagine that if you went to a plan sponsor and said you needed transaction-level information going all the way back to 2008, you're going to get a myriad of responses," he said. "Some can't do it; some only have data for some of the years."
Firms have to crunch the numbers to figure out whether or not a client was harmed, then calculate exactly how much to pay back. Though Finra suggested two approaches — an aggregate statistical approach or a customer-specific analysis — both will take significant time.
In addition to extending the deadline, Finra said it will be flexible with firms on timing. The regulator has set up a dedicated email account (529Initiative@finra.org) for firms to request an extension for either their initial supervisory review or for collecting the required information.
"I do think it's important to say that the first step of this initiative would not be data gathering; it's qualitatively assessing the supervisory process," Ms. Schroeder said.
For firms that ultimately decide not to participate, Finra won't automatically waive fines, but neither will it increase the sanctions it would have imposed before the initiative was offered.
Mr. Jolly thinks Finra's initiative is a good thing, but says it faces an uphill battle getting the industry to participate. It's like watching the referees in an NFL game: It can be hard to remember that the ones blowing the whistle and issuing penalties also have the players' best interests at heart.
"The point is, Finra is like this Big Brother that's always out there looking over your shoulders," Mr. Jolly said. "If you're not breaking the law, you've got nothing to worry about. But if I accidentally screw something up, am I going to get slapped on the wrist?"
The additional regulatory risk is unlikely to discourage many advisers from selling 529 plans, said Mark Kantrowitz, publisher and vice president of research at SavingForCollege.com. Finra is giving firms plenty of time to clean their act up before the regulator starts "knocking heads together."
Mr. Kantrowitz thinks the initiative will ultimately influence advisers to be more deliberate in assessing a client's risk tolerance and time horizon, which they should have been doing already.
"More families are contributing to 529 plans than previous years," he said. "That's why it's good that Finra is applying this extra scrutiny now."
Ross Riskin, assistant professor of taxation and CFP program director at The American College, suggested increased awareness around fees could actually be beneficial for adviser-sold plans, especially with the new tax law complicating share class suitability.
"It's not one-size-fits-all," Mr. Riskin said. "Working with a competent, well-informed adviser is still the right way to go with these things."