From Ulmer’s Broker-Dealer Law Corner Blog
By Alan M. Wolper
About a year ago, the SEC offered investment advisors the unique opportunity to report themselves to the SEC if they sold mutual funds to their clients that offered a lower priced share class than the class actually selected by the advisor, but failed adequately to disclose the conflict of interest that created. For those advisors willing to self-report under the Share Class Selection Disclosure Initiative – and pay their customers whatever excess fees they paid by having been improperly sold the higher priced share class – the SEC’s Enforcement Division promised that it would “recommend standardized, favorable settlement terms to investment advisers.” While these settlements haven’t quite gotten to the finish line yet – the first ones appear to be close to being finalized – it does seem that the SEC is going to honor that promise.
Well, I guess that FINRA saw this and said, hmmm, maybe we should do that, too. (FINRA is unique, perhaps, for being the only entity in the world that knowingly models its operations on those of a U.S. governmental agency, given the well-earned reputation among such agencies for, um, efficiency, fairness, and ease of process.) So, earlier this week, FINRA announced its own self-reporting initiative – the 529 Plan Share Class Initiative – this time for BDs, so they, too, can turn themselves in to their regulator for sales practice issues in exchange for the promise of (relatively) gentle treatment by Enforcement.
The concept is simple enough to describe:
- You’re a BD that sells 529 plans.
- Maybe you haven’t been paying particularly close attention to the share class that your reps are recommending to their customers, despite FINRA’s efforts to publicize this issue, and now realize that, oops, there were, in fact, cheaper share classes available, so your clients may have paid too much.
- You now face a choice: you can do nothing, and sit back and cross your fingers and hope that FINRA never stumbles on to your situation (which is theoretically possible, not because FINRA is incompetent, but because FINRA exams don’t review every single facet of your business, and, therefore, may not take a hard look at your 529 sales, especially if they represent a very small component of your revenue), or you can voluntarily report your supervisory lapse to FINRA under this Initiative and take your lumps with Enforcement (with the thought that those lumps won’t be nearly as bad as they would be if you don’t self-report and FINRA does manage to figure out on its own that you’ve been overcharging your customers).
This may or may not be an easy decision to make, for the simple reason that it may not be clear that the recommendation to use a share class with a higher fee was, in fact, not appropriate. In other words, to determine if you have a supervisory problem that FINRA is going to care about, it’s not just a matter of identifying the share class that was recommended and then seeing if a cheaper one was available. As FINRA itself recognizes, the choice of share class can be dictated by the anticipated period of time until the funds will be needed from the 529 plan to pay for the beneficiary’s education. For older beneficiaries, the hold period may be shorter, which could impact the choice of share class. The point is, the analysis is not simply an arithmetic one, but something more involved. And, the more customers you have, the lengthier and more involved that analysis becomes.
And, don’t forget that a condition to participating in the Initiative is your commitment to providing restitution back to your customers of whatever they overpaid as a result of being placed in a higher priced share class. That could be a lot of money, especially since FINRA is looking at 5 ½ year time period, from January 2013 through June 2018. For some firms, it may be enough money to justify the decision not to self-report and, instead, roll the dice that you somehow remain under FINRA’s radar.
So, if you are a firm that does think you have a problem with your 529 sales, it comes down to a couple of things. First, are you willing to risk that FINRA won’t find your problem. Second, can you afford the restitution that will be required. Third, if you don’t self-report and FINRA does discover your problem, would you be ok with the harsher treatment you’ll then receive. What will that entail? First, firms that self-report will not pay a fine; that is not necessarily going to be the case for firms that don’t self-report. According to FINRA, for a firm that does not participate in the Initiative that FINRA later discovers has a 529 share class problem,“any resulting disciplinary action likely will result in the recommendation of sanctions beyond those described under the initiative.”
Second, firms that self-report will likely all be lumped together when the settlements are announced. From a publicity standpoint – or, more accurately, bad publicity standpoint – it may be advantageous simply to be one of several (or many) firms that are listed in a press release than to be the sole subject of a standalone press release.
Regardless of whether a firm self-reports under the Initiative, FINRA will give no assurances that it will not also go after individuals it deems to have culpability. (The SEC provided the very same caution for its SCSD Initiative.) So, at least this is one thing that can be removed from the calculus in determining whether to self-report, since individual supervisors may face disciplinary action either way.
You have a little bit of time to mull this one over. The deadline for simply advising FINRA of your intent to self-report is April 1. After that, firms will have until May 3 to do the heavy lifting, i.e., to provide FINRA with all the crunched numbers and data relating to their 529 sales. That will likely represent a considerable amount of work, certainly not for the faint of heart.
On balance, I like this notion that FINRA copied/borrowed from the SEC. Particularly for firms that already know they face a 529 problem. Better to have the certainty of no fine, and of being just one firm in a crowd of other firms, than facing the uncertainty that accompanies the ordinary Enforcement action. I tend to be conservative, so I would not advise my clients to bet that FINRA won’t discover any existing 529 problems on its own. FINRA may not be good at all things, but (putting aside Allen Stanford) its examiners are fairly good at following the money, i.e., focusing their exams on the principal source(s) of a BD’s revenues. If the sale of 529s represents a material portion of a firm’s sales, then undoubtedly FINRA will pay attention to those sales, including the share class utilized. Given that likelihood, the risks of not participating in the Initiative are outweighed by the benefits of, gulp, turning oneself into FINRA.