MSRB Files Interpretation on Customer Protection Obligations Relating to the Marketing of 529 College Savings Plans with the SEC

The Municipal Securities Rulemaking Board (“MSRB”) has filed with the Securities and Exchange Commission (“SEC”) interpretive guidance (the “proposed interpretation”) relating to customer protection obligations of brokers, dealers and municipal securities dealers (“dealers”) marketing 529 college savings plans. [1] The proposed interpretation strengthens and clarifies dealers’ obligations to provide important disclosures to customers investing in out-of-state 529 college savings plans and to undertake active suitability analyses for recommended transactions in 529 college savings plans based on appropriately weighted factors.

BACKGROUND

In a May 14, 2002 notice (the “2002 Notice”), the MSRB interpreted Rule G-17, on fair dealing, to require dealers selling out-of-state 529 college savings plan interests to customers to disclose at or prior to the sale to the customer (the “time of trade”) that, depending upon the laws of the customer’s home state, favorable state tax treatment for investing in a 529 college savings plan may be limited to investments made in a 529 college savings plan offered by the customer’s home state.[2] In addition, the MSRB provided guidance in the 2002 Notice on the application of Rule G-19, on suitability of recommendations and transactions, and other customer protection rules in the context of 529 college savings plan transactions.

On June 10, 2004, the MSRB published for comment draft interpretive guidance relating to, among other things, the disclosure obligations of dealers selling out-of-state 529 college savings plans (the “2004 Proposal”). [3]  The 2004 Proposal proposed expanding the existing obligation of dealers under the 2002 Notice to advise their out-of-state 529 college savings plan customers of the potential loss of state tax benefits to also include reference to other potential in-state benefits that may be foregone.

The MSRB received comments on the 2004 Proposal from eight commentators. All commentators on the 2004 Proposal supported the importance of ensuring some degree of disclosure to customers of the existence of potential in-state benefits of 529 college savings plans but some commentators suggested changes to the specific proposal. After reviewing the comments on the 2004 Proposal, considering the concerns of NASD and others regarding high levels of out-of-state sales and consulting with SEC staff, the MSRB published on May 19, 2005 a notice seeking further comment on a revised version of the draft interpretive guidance (the “2005 Proposal”).[4]

The 2005 Proposal covered a wider range of topics than the portion of the 2004 Proposal relating to disclosure.  The 2005 Proposal sought to expand the time-of-trade disclosure obligation for out-of-state sales proposed in the 2004 Proposal to include a requirement that dealers identify for their out-of-state customers the specific tax and other benefits that each of their respective home states offer and that such customers would forego by investing in an out-of-state 529 college savings plan (the “special home state disclosure proposal”).  More broadly, the 2005 Proposal discussed general disclosure practices and mechanisms in the 529 college savings plan market, including the possible establishment of centralized information sources.  Dealers were reminded that disclosures made to customers do not relieve dealers of their suitability duties – including their obligation to consider the customer’s financial status, tax status and investment objectives – arising in connection with recommended transactions.  The 2005 Proposal discussed existing suitability standards as applied to recommendations of 529 college savings plan transactions and proposed expanding such standards to require dealers recommending out-of-state 529 college savings plan investments to undertake a comparative suitability analysis involving a comparison of the recommended out-of-state 529 college savings plan with the customer’s home state 529 college savings plan (the “comparative suitability proposal”). Finally, the 2005 Proposal discussed other sales practice obligations under the MSRB’s fair practice rule.

The MSRB received comments on the 2005 Proposal from 22 commentators.  Although some commentators supported the concept of centralized information sources for the 529 college savings plan market and the clarification of certain elements of existing disclosure and suitability obligations, the vast majority of commentators opposed any requirements to disclose specific in-state features foregone as a result of an out-of-state investment or to undertake a comparative suitability analysis.

The MSRB has considered the comments on the 2004 and 2005 Proposals, together with important developments in the mechanisms for ensuring the free and effective flow of information to the public about all 529 college savings plans offered in the marketplace (discussed below), in determining to file the proposed interpretation. Copies of the comment letters, together with a discussion of the comments and the MSRB’s responses, are included in the filing with the SEC and may be viewed at [SR-MSRB-2006-03].

FILING OF PROPOSED INTERPRETATION

The MSRB has strengthened the existing time-of-trade disclosure and basic suitability obligations as applied to transactions in 529 college savings plans.  However, in view of significant developments toward the maturation of the disclosure dissemination system for this market and with due regard to concerns expressed by the commentators and in press reports regarding the potentially substantial impact of the special home state disclosure and comparative suitability proposals,[5] the MSRB has determined at this time not to adopt these two proposals pending further assessment of the efficacy of developments in the disclosure infrastructure.

Summary of Proposed Interpretation

The proposed interpretation broadens the existing time-of-trade disclosure obligation with respect to the marketing of out-of-state 529 college savings plans.  Under the proposed interpretation, dealers selling out-of-state 529 college savings plan interests are required to disclose to the customer, at or prior to the time of trade, that:  (i) depending on the laws of the home state of the customer or designated beneficiary, favorable state tax treatment or other benefits offered by such home state may be available only if the customer invests in the home state’s 529 college savings plan; (ii) state-based benefits should be one of many appropriately weighted factors to be considered in making an investment decision; and (iii) the customer should consult with his or her financial, tax or other adviser about how such state-based benefits would apply to the customer’s specific circumstances and may wish to contact his or her home state or any other 529 college savings plan to learn more about their features (the “out-of-state disclosure obligation”).

Guidance is provided as to the manner of delivering this revised out-of-state disclosure to ensure that such information is noted by the customer.  The out-of-state disclosure obligation may be met through the issuer’s program disclosure document so long as the program disclosure document is provided to the customer at or prior to the time of trade and the required disclosure appears in a manner that is reasonably likely to be noted by an investor. Presentation of this disclosure in the program disclosure document in close proximity and with equal prominence to the principal presentation of substantive information on other federal or state tax-related matters, and the inclusion of a reference to this disclosure in close proximity and with equal prominence to each other presentation of information on state tax-related matters, would be deemed to satisfy this requirement. However, if a dealer determines that the issuer has not included the information in the program disclosure document in the manner described, inclusion in the program disclosure document in another manner may nonetheless fulfill the dealer’s out-of-state disclosure obligation so long as disclosure in such other manner is reasonably likely to be noted by an investor.  Otherwise, the dealer would remain obligated to disclose such information separately to the customer by no later than the time of trade.[6]  Dealers are also reminded that all disclosures made to customers, regardless of whether they are made pursuant to a regulatory mandate, must not be false or misleading.

The proposed interpretation further reminds dealers that providing disclosures to customers does not relieve them of their suitability duties – including their obligation to consider the customer’s financial status, tax status and investment objectives – arising in connection with recommended transactions. The proposed interpretation describes certain basic suitability principles applicable to recommended transactions in 529 college savings plans as originally described in the 2002 Notice and further advises dealers to consider whether a recommendation is consistent with the customer’s tax status and any federal or state tax-related investment objectives of the customer.  The proposed interpretation emphasizes that any dealer that recommends a transaction must undertake an active suitability process involving a meaningful analysis that takes into consideration information about the customer and the security and that is based on the various appropriately weighted factors that are relevant in any particular set of facts and circumstances.  Dealers must have and enforce written supervisory procedures reasonably designed to ensure compliance with this obligation for every recommended transaction.  Finally, the proposed interpretation reaffirms existing guidance from the 2002 Notice on other customer protection obligations applicable to dealer sales practices in the 529 college savings plan market.

529 College Savings Plan Disclosure Dissemination System

Since publishing the 2005 Proposal, the MSRB has engaged the 529 college savings plan industry and other federal securities regulators in a dialogue regarding the 2005 Proposal.  In particular, the MSRB has emphasized that a crucial factor underlying the proposed special home state disclosure and comparative suitability obligations for out-of-state sales was the difficulty that the average investor faces in obtaining and understanding the key items of information relevant in making an informed investment decision in the context of the varied and complex national 529 college savings plan marketplace.[7]

The MSRB has long been an advocate for the best possible disclosure practices by the 529 college savings plan community, having previously noted that investor protection concerns dictate that disclosure in this market should be based on six basic characteristics:  comprehensiveness, understandability, comparability, universality, timeliness and accessibility.[8] However, neither the MSRB nor SEC have the authority to mandate that 529 college savings plans make specific disclosures, including disclosure of costs associated with investments in the plans, descriptions of the state tax consequences of investing in their plans or in out-of-state plans, or disclosure of performance under uniform standards. [9]

The MSRB is of the view that a more comprehensive and user-friendly system of established industry sources [10] is needed in the 529 college savings plan market.  Such a system would be based on centralized websites providing direct access to official issuer disclosure materials for the entire universe of 529 college savings plan offerings, together with understandable educational information and tools allowing for side-by-side comparisons of different 529 college savings plans.  It is crucial that dealers and other investment professionals seeking to provide advice to their customers on their college savings options are able to do so with a full view of the available alternatives.  In addition, this maturation of the disclosure dissemination system for the 529 college savings plan market would be particularly crucial to allowing customers to have direct access to the types of information and other resources they need to make informed investment decisions, thereby promoting investor confidence in their own abilities to make such informed choices, whether with the advice of an investment professional or as a self-directed investor.

The MSRB understands that the College Savings Plan Network (“CSPN”) has undertaken to upgrade its existing website to provide a comprehensive centralized web-based utility for the 529 college savings plan market.  This CSPN utility is expected to provide a combination of on-site and hyperlinked resources, including summary information formatted to allow meaningful comparisons of many of the material features of different 529 college savings plans, together with direct links to all 529 college savings plan program disclosure documents and related information as well as to other sources providing tools designed for analyzing potential 529 college savings plan investments.  The MSRB understands that the types of material features to be disclosed through this utility include, but are not limited to, state tax treatment and other state-based benefits, costs associated with investments, types of underlying investments, performance information and other important features that can vary considerably from state to state, with hyperlinks embedded within such summary information providing direct links to a full description of such specific feature in the issuer’s official program disclosure document or other reliable sources.  CSPN has also recently published its Disclosure Principles Statement No. 2 (“DP-2”), which updates its baseline disclosure standards designed to assist the states in improving the quality and comparability of their 529 college savings plan disclosures in the program disclosure document.  In the 2005 Proposal, the MSRB had urged CSPN and the individual 529 college savings plans to strive for the maximum possible ease of access to, and uniformity of content in, the program disclosure documents consistent with providing information that is complete, understandable and not misleading.  The MSRB views the upcoming implementation of the CSPN website disclosure utility and the development and universal adoption of DP-2 as significant steps toward achieving the goals the MSRB had set out for the 529 college savings plan market.

The CSPN utility will join other commercial, industry group and regulator web-based resources providing useful information for individuals seeking to save for college expenses and for investment professionals active in the 529 college savings plan market.  Several commercial ventures already provide, in summary and often tabular form, some categories of information for all available 529 college savings plans. Such information can include fees and expenses, minimum and maximum investments, nature of the underlying investments, distribution channels, and state tax treatment, as well as proprietary ratings based on varying criteria.  Much of this information is available at no cost, with some sources making available, for a fee, premium or membership-based services for professionals that provide greater detail or more comprehensive analyses of the available information.  Many of these commercial websites have taken recent steps to augment and refine the information they offer to the public, and the MSRB understands that alternative pricing structures suitable for retail investors for access to these premium services are being considered.  In addition, the MSRB, SEC, NASD and the North American Securities Administrators Association (“NASAA”) all provide general information about investing in 529 college savings plans useful to individual investors and market participants. [11]  NASD plans to introduce on its website in the near future an improved expense analyzer for the 529 college savings plan market using a live datafeed that should allow for more reliable calculations and cost comparisons among different 529 college savings plans.  The CSPN utility is expected to serve as a central hub through which investors can easily access many of these other web-based resources.

The MSRB believes that improved disclosures can only be effective if potential investors actually access such disclosures with sufficient time to make use of the information in coming to an investment decision. The MSRB urges dealers and other participants in the 529 college savings plan market to provide the investing public with easy access to, and to affirmatively encourage the use of, this market-wide information.  The MSRB will monitor the 529 college savings plan market closely with respect to the concerns it sought to address through the 2005 Proposal.  The MSRB will be acutely sensitive to, and will consider whether further rulemaking would be appropriate in the event of, any significant failures in the further development of the disclosure dissemination system or in the efficacy of this dissemination system to address the MSRB’s stated investor protection concerns.

Effective Date

The MSRB has requested that the SEC delay the effectiveness of the proposed interpretation until the 60th calendar day after SEC approval to provide dealers with sufficient time to establish appropriate compliance procedures.   The MSRB reminds dealers that the obligations established under the 2002 Notice will continue to apply until the proposed interpretation becomes effective.  Dealers are urged to comply with the proposed interpretation as soon as practicable after SEC approval.

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Questions regarding the proposed interpretation may be directed to Ernesto A. Lanza, Senior Associate General Counsel, Jill C. Finder, Assistant General Counsel, or Ghassan Hitti, Assistant General Counsel.

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INTERPRETATION ON CUSTOMER PROTECTION OBLIGATIONS RELATING TO THE MARKETING OF 529 COLLEGE SAVINGS PLANS

The Municipal Securities Rulemaking Board (“MSRB”) is publishing this interpretation to ensure that brokers, dealers and municipal securities dealers (“dealers”) effecting transactions in the 529 college savings plan market fully understand their fair practice and disclosure duties to their customers.[1]

Basic Customer Protection Obligation

At the core of the MSRB’s customer protection rules is Rule G-17, which provides that, in the conduct of its municipal securities activities, each dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest or unfair practice.  The rule encompasses two basic principles:  an anti-fraud prohibition similar to the standard set forth in Rule 10b-5 adopted by the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 (the “Exchange Act”), and a general duty to deal fairly even in the absence of fraud.  All activities of dealers must be viewed in light of these basic principles, regardless of whether other MSRB rules establish specific requirements applicable to such activities.

Disclosure

The MSRB has interpreted Rule G-17 to require a dealer, in connection with any transaction in municipal securities, to disclose to its customer, at or prior to the sale of the securities to the customer (the “time of trade”), all material facts about the transaction known by the dealer, as well as material facts about the security that are reasonably accessible to the market.[2]  This duty applies to any dealer transaction in a 529 college savings plan interest regardless of whether the transaction has been recommended by the dealer.

Many states offer favorable state tax treatment or other valuable benefits to their residents in connection with investments in their own 529 college savings plan.  In the case of sales of out-of-state 529 college savings plan interests to a customer, the MSRB views Rule G-17 as requiring a dealer to make, at or prior to the time of trade, additional disclosures that:

(i) depending upon the laws of the home state of the customer or designated beneficiary, favorable state tax treatment or other benefits offered by such home state for investing in 529 college savings plans may be available only if the customer invests in the home state’s 529 college savings plan;

(ii) any state-based benefit offered with respect to a particular 529 college savings plan should be one of many appropriately weighted factors to be considered in making an investment decision; and

(iii) the customer should consult with his or her financial, tax or other adviser to learn more about how state-based benefits (including any limitations) would apply to the customer’s specific circumstances and also may wish to contact his or her home state or any other 529 college savings plan to learn more about the features, benefits and limitations of that state’s 529 college savings plan.

This disclosure obligation is hereinafter referred to as the “out-of-state disclosure obligation.”[3]

The out-of-state disclosure obligation may be met if the disclosure appears in the program disclosure document, so long as the program disclosure document has been delivered to the customer at or prior to the time of trade and the disclosure appears in the program disclosure document in a manner that is reasonably likely to be noted by an investor.[4]  A presentation of this disclosure in the program disclosure document in close proximity and with equal prominence to the principal presentation of substantive information regarding other federal or state tax-related consequences of investing in the 529 college savings plan, and the inclusion of a reference to this disclosure in close proximity and with equal prominence to each other presentation of information regarding state tax-related consequences of investing in the 529 college savings plan, would be deemed to satisfy this requirement.[5]

The MSRB has no authority to mandate inclusion of any particular items in the issuer’s program disclosure document.[6]  Dealers who wish to rely on the program disclosure document for fulfillment of the out-of-state disclosure obligation are responsible for understanding what is included within the program disclosure document of any 529 college savings plan they market and for determining whether such information is sufficient to meet this disclosure obligation.  Notwithstanding any of the foregoing, disclosure through the program disclosure document as described above is not the sole manner in which a dealer may fulfill its out-of-state disclosure obligation.   Thus, if the issuer has not included this information in the program disclosure document in the manner described, inclusion in the program disclosure document in another manner may nonetheless fulfill the dealer’s out-of-state disclosure obligation so long as disclosure in such other manner is reasonably likely to be noted by an investor.  Otherwise, the dealer would remain obligated to disclose such information separately to the customer under Rule G-17 by no later than the time of trade.[7]

If the dealer proceeds to provide information to an out-of-state customer about the state tax or other benefits available through such customer’s home state, Rule G-17 requires that the dealer ensure that the information is not false or misleading.  For example, a dealer would violate Rule G-17 if it were to inform a customer that investment in the 529 college savings plan of the customer’s home state did not provide the customer with any state tax benefit even though such a state tax benefit is in fact available.  Furthermore, a dealer would violate Rule G-17 if it were to inform a customer that investment in the 529 college savings plan of another state would provide the customer with the same state tax benefits as would be available if the customer were to invest in his or her home state’s 529 college savings plan even though this is not the case.[8]   Dealers should make certain that information they provide to their customers, whether provided under an affirmative disclosure obligation imposed by MSRB rules or in response to questions from customers, is correct and not misleading.

Dealers are reminded that this out-of-state disclosure obligation is in addition to their general obligation under Rule G-17 to disclose to their customers at or prior to the time of trade all material facts known by dealers about the 529 college savings plan interests they are selling to their customers, as well as material facts about such 529 college savings plan that are reasonably accessible to the market.  Further, dealers are reminded that disclosures made to customers as required under MSRB rules with respect to 529 college savings plans do not relieve dealers of their suitability obligations – including the obligation to consider the customer’s financial status, tax status and investment objectives – if they have recommended investments in 529 college savings plans.

Suitability

Under Rule G-19, a dealer that recommends to a customer a transaction in a security must have reasonable grounds for believing that the recommendation is suitable, based upon information available from the issuer of the security or otherwise and the facts disclosed by or otherwise known about the customer. [9]  To assure that a dealer effecting a recommended transaction with a non-institutional customer has the information needed about the customer to make its suitability determination, the rule requires the dealer to make reasonable efforts to obtain information concerning the customer’s financial status, tax status and investment objectives, as well as any other information reasonable and necessary in making the recommendation. [10]  Dealers are reminded that the obligation arising under Rule G-19 in connection with a recommended transaction requires a meaningful analysis, taking into consideration the information obtained about the customer and the security, that establishes the reasonable grounds for believing that the recommendation is suitable.  Such suitability determinations should be based on the appropriately weighted factors that are relevant in any particular set of facts and circumstances, which factors may vary from transaction to transaction. [11]  Pursuant to Rule G-27(c), dealers must have written supervisory procedures in place that are reasonably designed to ensure compliance with this Rule G-19 obligation to undertake a suitability analysis in connection with every recommended transaction, and dealers must enforce these procedures to ensure that such meaningful analysis does in fact occur in connection with the dealer’s recommended transactions.

In the context of a recommended transaction relating to a 529 college savings plan, the MSRB believes that it is crucial for dealers to remain cognizant of the fact that these instruments are designed for a particular purpose and that this purpose generally should match the customer’s investment objective.  For example, dealers should bear in mind the potential tax consequences of a customer making an investment in a 529 college savings plan where the dealer understands that the customer’s investment objective may not involve use of such funds for qualified higher education expenses.[12]  Dealers also should consider whether a recommendation is consistent with the customer’s tax status and any customer investment objectives materially related to federal or state tax consequences of an investment.

Furthermore, investors generally are required to designate a specific beneficiary under a 529 college savings plan.  The MSRB believes that information known about the designated beneficiary generally would be relevant in weighing the investment objectives of the customer, including (among other things) information regarding the age of the beneficiary and the number of years until funds will be needed to pay qualified higher education expenses of the beneficiary.  The MSRB notes that, since the person making the investment in a 529 college savings plan retains significant control over the investment (e.g., may withdraw funds, change plans, or change beneficiary, etc.), this person is appropriately considered the customer for purposes of Rule G-19 and other MSRB rules.  As noted above, information regarding the designated beneficiary should be treated as information relating to the customer’s investment objective for purposes of Rule G-19.

In many cases, dealers may offer the same investment option in a 529 college savings plan sold with different commission structures.  For example, an A share may have a front-end load, a B share may have a contingent deferred sales charge or back-end load that reduces in amount depending upon the number of years that the investment is held, and a C share may have an annual asset-based charge.  A customer’s investment objective – particularly, the number of years until withdrawals are expected to be made – can be a significant factor in determining which share class would be suitable for the particular customer.

Rule G-19(e), on churning, prohibits a dealer from recommending transactions to a customer that are excessive in size or frequency, in view of information known to such dealer concerning the customer’s financial background, tax status and investment objectives.  Thus, for example, where the dealer knows that a customer is investing in a 529 college savings plan with the intention of receiving the available federal tax benefit, such dealer could, depending upon the facts and circumstances, violate rule G-19(e) if it were to recommend roll-overs from one 529 college savings plan to another with such frequency as to lose the federal tax benefit.  Even where the frequency does not imperil the federal tax benefit, roll-overs recommended year after year by a dealer could, depending upon the facts and circumstances (including consideration of legitimate investment and other purposes), be viewed as churning.  Similarly, depending upon the facts and circumstances, where a dealer recommends investments in one or more plans for a single beneficiary in amounts that far exceed the amount that could reasonably be used by such beneficiary to pay for qualified higher education expenses, a violation of rule G-19(e) could result.[13]

Other Sales Practice Principles

Dealers must keep in mind the requirements under Rule G-17 – that they deal fairly with all persons and that they not engage in any deceptive, dishonest or unfair practice – when considering the appropriateness of day-to-day sales-related activities with respect to municipal fund securities, including 529 college savings plans.  In some cases, certain sales-related activities are governed in part by specific MSRB rules, such as Rule G-19 (as described above) and Rule G-30(b), on commissions. [14]  Other activities may not be explicitly addressed by a specific MSRB rule.  In either case, the general principles of Rule G-17 always apply.

In particular, dealers must ensure that they do not engage in transactions primarily designed to increase commission revenues in a manner that is unfair to customers under Rule G-17.  Thus, in addition to being a potential violation of Rule G-19 as discussed above, recommending a particular share class to a customer that is not suitable for that customer, or engaging in churning, may also constitute a violation of Rule G-17 if the recommendation was made for the purpose of generating higher commission revenues.  Also, where a dealer offers investments in multiple 529 college savings plans, consistently recommending that customers invest in the one 529 college savings plan that offers the dealer the highest compensation may, depending on the facts and circumstances, constitute a violation of Rule G-17 if the recommendation of such 529 college savings plan over the other 529 college savings plans offered by the dealer does not reflect a legitimate investment-based purpose.

Further, recommending transactions to customers in amounts designed to avoid commission discounts (i.e., sales below breakpoints where the customer would be entitled to lower commission charges) may also violate Rule G-17, depending upon the facts and circumstances.  For example, a recommendation that a customer make two smaller investments in separate but nearly identical 529 college savings plans for the purposes of avoiding a reduced commission rate that would be available upon investing the full amount in a single 529 college savings plan, or that a customer time his or her multiple investments in a 529 college savings plan so as to avoid being able to take advantage of a lower commission rate, in either case without a legitimate investment-based purpose, could violate Rule G-17.

With respect to sales incentives, the MSRB has previously interpreted Rule G-20, relating to gifts, gratuities and non-cash compensation, to require a dealer that sponsors a sales contest involving representatives who are not employed by the sponsoring dealer to have in place written agreements with these representatives.[15]  In addition, the general principles of Rule G-17 are applicable.  Thus, if a dealer or any of its associated persons engages in any marketing activities that result in a customer being treated unfairly, or if the dealer or any of its associated persons engages in any deceptive, dishonest or unfair practice in connection with such marketing activities, Rule G-17 could be violated.  The MSRB believes that, depending upon the specific facts and circumstances, a dealer may violate Rule G-17 if it acts in a manner that is reasonably likely to induce another dealer or such other dealer’s associated persons to violate the principles of Rule G-17 or other MSRB customer protection rules, such as Rule G-19 or Rule G-30.  Dealers are also reminded that Rule G-20 establishes standards regarding incentives for sales of municipal securities, including 529 college savings plan interests, that are substantially similar to those currently applicable to sales of mutual fund shares under NASD rules.