MSRB NOTICE 2005-28 (MARCH 19, 2005)

REQUEST FOR COMMENTS ON DRAFT INTERPRETATION ON CUSTOMER PROTECTION OBLIGATIONS RELATING TO THE MARKETING OF 529 COLLEGE SAVINGS PLANS

Introduction

On May 14, 2002, the Municipal Securities Rulemaking Board (“MSRB”) published interpretive guidance on the basic customer protection obligations that brokers, dealers and municipal securities dealers (“dealers”) have when effecting transactions in municipal fund securities (the “2002 Notice”).[1] During the three years since publication of the 2002 Notice, the 529 college savings plan (“529 plan”) market has evolved and grown considerably, becoming a much more complex market involving a wider variety of investment options, a more diversified distribution system, and a constantly shifting backdrop of state tax treatment and other state-specific benefits and limitations.[2] In addition, concerns have been expressed about the quality of 529 plan disclosure, including the ability of investors to make meaningful comparisons among 529 plans; varying state tax treatment; the levels of fees and commissions charged in the 529 plan market; and questionable dealer sales practices. These concerns have triggered Congressional hearings on the 529 plan market and the formation of the Chairman’s Task Force on College Savings Plans by the Securities and Exchange Commission (“SEC”) to review market practices. Further, NASD has preliminarily found that many dealers market 529 plans predominantly to customers who are not residents of the state that offers the 529 plans sold, calling into question whether dealers are adequately undertaking suitability determinations in connection with their recommended transactions.[3]

As a result, the MSRB today is publishing for comment additional interpretive guidance on the disclosure, suitability and other customer protection obligations of dealers in connection with their marketing of 529 plans.

Background

Advertising and Non-Cash Compensation. The 2002 Notice had provided guidance on dealer advertisements of municipal fund securities under Rule G-21, on advertising, as well as on dealer sales practices involving gifts or other sales inducements under Rule G-20, on gifts and gratuities, and Rule G-17, on fair dealing. In June 2004, the MSRB published for comment two rulemaking proposals that sought to substantially expand upon portions of the guidance provided in the 2002 Notice. On June 10, 2004, the MSRB published for comment draft amendments to Rule G-21 relating to advertisements of municipal fund securities and draft interpretive guidance on disclosures in connection with out-of-state sales of 529 plan shares.[4] The MSRB subsequently filed the advertising amendments with the SEC on December 16, 2004, at which time the MSRB also published for comment certain additional draft amendments to Rule G-21 to supplement the original amendments.[5] In addition, on June 15, 2004, the MSRB published for comment draft amendments to Rule G-20 to (among other things) incorporate provisions relating to non-cash compensation that would parallel existing requirements that apply to mutual fund sales.[6] The MSRB subsequently filed the Rule G-20 amendments with the SEC on January 13, 2005.

Disclosures in Connection with Out-of-State Sales of 529 Plan Shares. In the 2002 Notice, the MSRB had established for the first time a requirement under Rule G-17 that dealers disclose to customers the potential loss of state tax benefits if investing in an out-of-state 529 plan rather than in the home state 529 plan. The MSRB has continued to review issues pertaining to the circumstances when a dealer markets a state’s 529 plan to a customer who is not a resident of that state. The MSRB has also reviewed the comments it received on the portion of the June 10, 2004 notice relating to the draft interpretive guidance on disclosures in connection with out-of-state sales of 529 plan shares.[7] These comments are discussed briefly below and have been carefully considered in the process of drafting portions of the draft interpretation that is being published today and appears below.

All commentators supported the importance of ensuring some degree of disclosure to customers of state-specific features of 529 plans but many suggested technical changes, took issue with various portions of the draft interpretive guidance, or sought more extensive point-of-sale disclosures. Some commentators questioned whether the MSRB should be establishing presentation standards for satisfying the proposed disclosure requirement in the program disclosure document. Others suggested that the MSRB adopt language to the same general effect as language included in the Voluntary Disclosure Principles Statement No. 1 adopted on December 2, 2004 by the College Savings Plan Network, an affiliate of the National Association of State Treasurers.

Some commentators emphasized that assessing the state-to-state differences in tax treatment and other unique features of 529 plans is extremely complex and expressed concern that disclosure at the point-of-sale of these issues may be incomplete and, therefore, possibly misleading. In addition, they stated that not every difference in state treatment ultimately will be a benefit to the investor. They suggested that the best course would be to remind investors to carefully review the program disclosure document of their home state programs and to consult their own advisors before investing. However, one commentator stated that it would be inappropriate to suggest to investors that they seek help from their home state programs because it is unclear whether the programs can provide complete information regarding such consequences and because some states may seek to persuade investors to make an investment in their program rather than to impart disinterested information. This commentator also was concerned about the potential for over-emphasizing state variations in a way that may detract from more fundamental considerations in making an investment decision.

Two commentators stated that the MSRB should put in place a broader set of disclosure requirements to accompany the proposed disclosures described in the draft guidance. One commentator suggested that the MSRB require standardized point-of-sale disclosure of fees and compensation in a manner similar to the point-of-sale disclosure requirements included by the SEC in its proposed Exchange Act Rule 15c2-3.[8] The proposed rulemaking by the SEC would apply to dealer sales of 529 plan interests, in addition to sales of mutual funds and variable annuities. Another commentator described an academic study on the tax and non-tax factors that influence investors’ choices of 529 plans and concluded that “investors appear to be choosing high fee/broker sold funds rather than the lower fee, direct investment options . . . [and] appear to be ignoring state tax benefits.” Stating that its study suggested that investors may not have sufficient information in these areas, this commentator supported mandating disclosure of not only state tax benefits but also uniform disclosure of fees and performance for each 529 plan portfolio and for each underlying fund in such portfolio, as well as the percentage of total investments that each underlying fund represents with respect to such 529 plan portfolio.

Revised Draft Interpretation

The MSRB agrees that understanding the full repercussions of state tax and other state law treatment of investments in 529 plans can be extraordinarily difficult and time consuming. The MSRB also agrees that not all differences in treatment necessarily result in a net benefit to any particular customer. The MSRB has previously stated that there is a potential for over-emphasizing the importance of a particular state’s beneficial state tax treatment of an investment in its 529 plan, such as where a state offers a tax benefit that ultimately is relatively small in value compared to the financial impact that a marginally higher expense figure may have. As a result, the MSRB has stated that any state tax benefits offered with respect to a particular 529 plan should be considered as one of many appropriately weighted factors that have an ultimate influence on a customer’s investment decision.[9]

The MSRB has been informed that some dealers may have taken the view that the disclosure obligation with respect to out-of-state investments established in the 2002 Notice was intended to conclusively limit the obligation of dealers to make disclosures at the point-of-sale with respect to state tax matters solely to the statement that the investor’s home state may offer state tax benefits only for in-state investments. In addition, some dealers may have taken the view that this disclosure obligation was intended to obviate the need to consider any state tax matters when making a suitability determination in connection with a recommended transaction. Both of these views are unwarranted, as the specific disclosures first established under the 2002 Notice do not limit the previously existing obligation under Rule G-17 for dealers to disclose at the point-of-sale all material facts known by dealers about the 529 plan interests they are selling to customers, as well as material facts about such investments reasonably accessible to the market through established industry sources.[10] Further, these specific disclosures do not relieve dealers of their suitability obligations – including their obligation to consider the customer’s financial status, tax status and investment objectives – if they have recommended the transaction.

In view of the changes to the 529 plan market, the challenges that this market faces, the preliminary findings of NASD and the apparent misunderstanding of the interplay between disclosure and suitability requirements – as well as after consultations with SEC staff – the MSRB believes that it would be appropriate to provide further guidance in this area. To that end, the MSRB is publishing the following draft interpretation for industry comment. In order to ensure that dealers fully understand their fair practice and disclosure duties to their customers in the specific context of the 529 plan market, the draft interpretation provides a substantially more detailed discussion of several areas previously reviewed in the 2002 Notice.[11]

The MSRB welcomes comments from all interested parties on all aspects of the draft interpretive guidance that follows.  Comments should be submitted no later than July 29, 2005 and may be directed to Ernesto A. Lanza, Senior Associate General Counsel, or Ghassan Hitti, Assistant General Counsel.  Written comments will be available for public inspection.

May 19, 2005

* * * * *

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

The 529 college savings plan (“529 plan”) market is continuously evolving and represents a unique intersection between the investment company market and the public sector financial market.[1]  The convergence of these two seemingly dissimilar markets can result in some confusion as to how otherwise familiar customer protection rules of fair practice and disclosure are meant to apply to the activities of brokers, dealers and municipal securities dealers (“dealers”) with their customers.  The Municipal Securities Rulemaking Board (“MSRB”) is publishing this interpretation to ensure that dealers in this market fully understand their fair practice and disclosure duties to their customers.  The MSRB emphasizes that the guidance provided in this interpretation, except where otherwise specifically noted, applies to dealer activities solely in the 529 plan market and necessarily arises from the unique context of this market.

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

Point-of-Sale Disclosures and Established Industry Sources .  The MSRB has previously interpreted Rule G-17 to require a dealer to disclose to its customer at or prior to the time of trade (or point-of-sale) all material facts about a municipal security transaction (including a 529 plan transaction) known by the dealer, as well as material facts about the municipal security that are reasonably accessible to the market.[2]  Thus, a dealer would be responsible for disclosing to a customer any material fact concerning a municipal security transaction made publicly available through sources such as the system of nationally recognized municipal securities information repositories (“NRMSIRs”), the MSRB’s Municipal Securities Information Library® system and Real-Time Transaction Reporting System (“RTRS”), rating agency reports and other sources of information relating to the municipal securities transaction generally used by dealers that effect transactions in the type of municipal securities at issue (collectively, “established industry sources”).  This duty applies in every transaction, regardless of whether the transaction has been recommended by the dealer.

In considering what would constitute established industry sources, the MSRB has observed that the customs and practices of the industry suggest that the sources of information generally used by a dealer that effects transactions in municipal securities may vary with the type of municipal security.  Among other things, a more complex security generally would dictate that a dealer take into account a broader range of information sources than it would for a simpler security.[3]  Due to the complexity of the 529 plan market and the decentralized nature of information sources in this market, the MSRB views established industry sources for the 529 plan market as encompassing a broad variety of information sources that professionals in this marketplace can and do use to obtain material information about these investments and the programs through which they are issued.[4]

For example, each 529 plan currently hosts an internet website where information concerning the plan, including the program disclosure document,[5] can be reviewed.  Centralized directories of links to these websites are available from a number of sources, including the website of the College Savings Plan Network (“CSPN”) and certain commercial websites devoted exclusively or in part to the 529 plan market.  The MSRB views these centralized websites providing links to the official 529 plan websites, as well as such official 529 plan websites themselves (whether accessed directly or through one of the centralized websites), as established industry sources for information on 529 plans.

Many of the centralized websites also provide, in summary and often tabular form, some categories of information for all available 529 plans.  Such information can include fees and expenses, minimum and maximum 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.  However, some of these key items of data – particularly information on state tax treatment and fees and expenses – are extremely complex and are difficult to fully summarize in tabular or similar presentations without a significant risk that material facts may be omitted or may not be fully explained.  Thus, for a user to fully understand the potential fees and expenses of investing in a particular 529 plan, the potential state tax ramifications for making such an investment, the specific nature of the securities underlying a particular investment option, and a host of other matters, additional diligence must be exercised, including the review of the current program disclosure document and any other relevant information available from the official 529 plan website or other readily available materials of the 529 plan.  In the MSRB’s view, a dealer cannot be satisfied that it has discovered all material facts about a 529 plan available from established industry sources merely by reviewing information available from one of these centralized websites unless it has previously determined through its own diligence that any such website does in fact provide sufficiently complete and timely information that would otherwise be available from the official 529 plan website or other readily available materials of the 529 plan.

The MSRB seeks comment on the feasibility of creating one or more centralized websites (or enhancing existing web-based resources) that would provide on-site summary information formatted to allow dealers and customers to make meaningful comparisons of the material features of 529 plans, together with direct links to all 529 plan program disclosure documents and related information.  The types of material features summarized on such a site would include, but not be limited to, state tax treatment and other state-based benefits (as hereinafter defined) and costs associated with investments and performance information, with the ability to easily access more detailed information directly from the summary information.[6]  The goal of such on-line sites would be to provide summary information that is sufficiently complete and understandable to permit dealers to fully rely on the websites to meet their obligation to review established industry sources.  Is such a centralized resource feasible on a commercial basis or by the appropriate industry organizations, or should the MSRB itself seek to establish a centralized hub for free and ready access to such material information for dealers and investors?  The MSRB notes that such a centralized hub would require significant resources to establish and maintain.  Were the MSRB to establish such a resource, its prior decision to exempt 529 plan offerings from the underwriting assessment established under Rule A-13 would need to be revisited to ensure adequate funding for its establishment and operation.

The MSRB believes that more comprehensive and complete centralized websites could greatly streamline the process dealers must currently undertake to satisfy their obligation to review what information is available from established industry sources.  In addition, such streamlining would greatly improve direct customer access to such information, which is particularly crucial in circumstances where customers may make investments directly through 529 plans without the assistance of dealers.

The program disclosure documents prepared by 529 plans are not required to conform to the prospectus requirements of the Investment Company Act, which establish uniform standards for disclosure in the mutual fund industry.[7]  However, the MSRB observes that CSPN has adopted Disclosure Principles Statement No. 1, which is intended to establish baseline standards for disclosure that have assisted in improving the quality and comparability of disclosures made by an increasing number of 529 plans.  Although the MSRB understands that the program disclosure documents for 529 plans are available at no cost on the internet, dealers and investors wishing to review program disclosure documents must navigate through widely varying websites to find such documents.  It is hoped that, once universal adoption of the Disclosure Principles is attained, users will be able to navigate the program disclosure documents themselves with some ease to find the desired information.  The MSRB urges CSPN and the individual 529 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.

Special Disclosure Considerations in Connection with Availability of State-Based Benefits.  The MSRB believes that Rule G-17 prohibits a dealer from misleading a customer regarding the availability of state tax benefits or other valuable benefits[8] offered by the state in connection with an investment in a 529 plan (collectively referred to as “state-based benefits”).  For example, a dealer would violate Rule G-17 if it were to inform a customer that investment in the 529 plan of the customer’s own state did not provide the customer with any state tax benefit when the dealer knows or has reason to know that such a state tax benefit likely would be available.  Furthermore, a dealer would violate Rule G-17 if it were to inform a customer that investment in the 529 plan of another state would provide the customer with the same tax benefits as would be available if the customer were to invest in his or her own state’s 529 plan, if the dealer knows or has reason to know that this is not the case.[9]  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.

In the case of sales to a customer of out-of-state 529 plan interests, the MSRB has determined to modify its existing view of a dealer’s Rule G-17 disclosure obligation to now require the dealer to disclose, at or prior to the time of trade, that, depending upon the laws of the home state of the customer or designated beneficiary, favorable state-based benefits offered by the state in connection with investing in 529 plans may be available only if the customer invests in a 529 plan offered by the home state of the customer or designated beneficiary.[10]  The dealer also must advise the customer that any state-based benefit offered with respect to a particular 529 plan should be considered as one of many appropriately weighted factors that should be considered by the customer in making his or her investment decision.

To comply with this point-of-sale disclosure requirement, the dealer has a duty to inquire whether the customer or designated beneficiary is a resident of the state of the 529 plan being marketed to the customer.  If the customer or designated beneficiary is not, the MSRB has determined to require that, concomitant with this inquiry and after advising the customer of the possible loss of state-based benefits offered by the home state, the dealer must inquire whether realizing state-based benefits is an important factor in the customer’s investment decision.  If the customer indicates that realizing state-based benefits is an important factor, the dealer is then required to disclose material information available from established industry sources about state-based benefits offered by the home state of the customer or designated beneficiary for investing in its 529 plan and whether such state-based benefits are available in the case of an investment in an out-of-state 529 plan.  In conjunction with this newly-required disclosure, the dealer also must suggest that the customer consult with his or her financial, tax or other adviser to learn more about how such home state features (including any limitations) may apply to the customer’s specific circumstances, and that the customer also may wish to contact his or her home state or any other 529 plan to learn more about any state-based benefits (and any limitations thereto) that might be available in conjunction with an investment in that state’s 529 plan.[11]

Dealers are reminded that this specific disclosure obligation with respect to sales of out-of-state 529 plan interests – which involves providing information to the customer about an investment option other than the 529 plan interests being offered by such dealers – is in addition to their existing general obligation under Rule G-17 to disclose to their customers at the point-of-sale all material facts known by dealers about the 529 plan interests they are selling to the customers, as well as material facts about such 529 plan that are reasonably accessible to the market through established industry sources.  Further, dealers are reminded that disclosures made to customers as required under MSRB rules with respect to 529 plans do not relieve dealers of their suitability obligations – including their obligation to consider the customer’s financial status, tax status and investment objectives – if they have recommended investments in 529 plans, as discussed below.

Point-of-Sale Disclosure Through the Program Disclosure Document.  The general point-of-sale disclosure obligation under Rule G-17 may be satisfied if the material information required to be disclosed pursuant to that obligation 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.[12]  With respect to the disclosure regarding state-based benefits, 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 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 plan, would be deemed to satisfy this requirement.[13]  Of course, if the dealer is required to provide to an out-of-state customer information about state-based benefits of his or her home state 529 plan, such disclosure likely would not be included in the program disclosure document of the out-of-state 529 plan and would need to be provided separately.[14]

The MSRB acknowledges that it has no authority to mandate inclusion of any particular items in the program disclosure document and issuers are free to include in their program disclosure document only such information as they deem appropriate in the manner they deem appropriate.[15]  Dealers who wish to rely on the program disclosure document for fulfillment of their disclosure obligations under Rule G-17 are responsible for understanding what is included within the program disclosure document of any 529 plan they market and for determining whether such information is sufficient to meet the dealers’ 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 obligation to make the required disclosures under Rule G-17.  Thus, if the issuer has not included the material information that the dealer is required to disclose under Rule G-17, or if such information is not presented in the program disclosure document with adequate prominence, the dealer would remain obligated to disclose such information separately to the customer under Rule G-17 by no later than the point-of-sale.

Suitability of Recommended Transactions

General Requirements.  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.[16]  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.[17]  Dealers are reminded that the obligation arising under Rule G-19 in connection with a recommended transaction requires a meaningful analysis that establishes the reasonable grounds for believing that the recommendation is suitable.  Pursuant to Rule G-27(c), dealers must have written supervisory procedures in place that are reasonably designed to ensure compliance with this obligation to undertake a suitability analysis in connection with every recommended transaction under Rule G-19, 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 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 plan where the dealer understands that the customer’s investment objective may not involve use of such funds for qualified higher education expenses.[18]  Furthermore, investors generally are required to designate a specific beneficiary under a 529 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 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 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 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 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.[19]

Additional Requirements in Connection With Out-of-State Sales.  Due to the unique nature of the 529 plan market, the MSRB has determined to now require that a dealer recommending an out-of-state 529 plan to a customer who has indicated that one of his or her investment objectives is the realization of state-based benefits to take this factor into account in undertaking a suitability determination.  This would involve – in addition to the traditional suitability analysis to establish the existence of reasonable grounds for recommending the offered security to the customer based on information about that offered security – the consideration of the state-based benefits available from the customer’s home state 529 plan in a comparative analysis with the out-of-state 529 plan being offered.  Of course, any state-based benefits offered with respect to a particular 529 plan should be considered as but one of many appropriately weighted factors that have an ultimate bearing on the relative strengths of a particular investment, and the existence of state-based benefits does not create a presumption that investment in the home state 529 plan is necessarily superior to an out-of-state 529 plan.

Thus, depending on the facts and circumstances in connection with a specific customer, it is possible that a dealer undertaking this new comparative suitability analysis might conclude that an investment in the home state 529 plan would be superior to an investment in the offered out-of-state 529 plan under every reasonable scenario.  In this case, the dealer would be obligated to inform the customer of this determination and would be permitted to effect a transaction in the offered out-of-state 529 plan only if (1) an investment in such out-of-state 529 plan would be considered suitable for the particular investor under traditional suitability standards (i.e., without regard to the comparison with the 529 plan of the customer’s home state), and (2) the customer nonetheless directs that the dealer effect the transaction after having been informed of the dealer’s determination that an investment in the 529 plan of the customer’s home state would be more suitable.[20]  A dealer effecting a transaction under these circumstances would be required to maintain records of any such customer directions and such transactions would require prompt review and approval by a principal.  If a customer is making periodic investments pursuant to such a direction, the dealer must confirm such direction at least annually.

Other Sales-Related Activities

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 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.[21]  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 plans, consistently recommending that customers invest in the one 529 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 plan over the other 529 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 invest in two separate but nearly identical municipal fund securities for the purposes of avoiding a reduced commission rate that would be available upon purchasing a larger quantity of a single such security, or that a customer time his or her multiple investments in a municipal fund security 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 and gratuities, 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.[22]  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 the MSRB has filed with the SEC proposed amendments to Rule G-20 in connection with non-cash compensation that, when approved by the SEC, would establish standards regarding incentives for sales of municipal securities, including 529 plan interests, that are substantially similar to those currently applicable to sales of mutual fund shares.


Footnotes to Request for Comment

[2] 529 college savings plans are established by states under Section 529(b)(A)(ii) of the Internal Revenue Code as “qualified tuition programs” through which individuals make investments for the purpose of accumulating savings for qualifying higher education costs of beneficiaries.  Section 529 of the Internal Revenue Code also permits the establishment of so-called prepaid tuition plans by states and higher education institutions.  All references to 529 plans are intended to encompass only 529 college savings plans established under Section 529(b)(A)(ii).

[3] See Oversight Hearing on 529 College Savings Plans, Hearing Before the Subcomm. on Financial Management, The Budget, and International Security of the Senate Comm. on Governmental Affairs, 108th Cong. (2004) (testimony of Mary L. Schapiro, Vice Chairman and President, Regulatory Policy and Oversight, NASD).

[7] The draft guidance sought to extend the existing disclosure obligation under Rule G-17 with respect to the possible loss of state tax benefits if investing in an out-of-state 529 plan to also include disclosure about the possible loss of other state-based benefits, as well as to establish certain presentation standards for satisfying this disclosure obligation through the program disclosure document.

[9] See Oversight Hearing on 529 College Savings Plans, Hearing Before the Subcomm. on Financial Management, The Budget, and International Security of the Senate Comm. on Governmental Affairs, 108th Cong. (2004) (testimony of Ernesto A. Lanza, Senior Associate General Counsel, MSRB).

[10] See Rule G-17 Interpretation – Interpretive Notice Regarding Rule G-17, on Disclosure of Material Facts, March 20, 2002, published in MSRB Rule Book.

[11] For example, the draft interpretation substantially reworks the draft interpretive guidance published on June 10, 2004 and provides new guidance as to the broader disclosure requirements under Rule G-17.  In addition, the draft interpretation significantly expands upon the discussion of suitability that appears in the 2002 Notice.  Other portions of the 2002 Notice are also included in the draft interpretation with little or no change as the 2002 Notice will be superseded once the draft interpretation, as well as the advertising and Rule G-20 amendments described above, become effective.

Footnotes to Draft Interpretation

[1] 529 college savings plans are established by states under Section 529(b)(A)(ii) of the Internal Revenue Code as “qualified tuition programs” through which individuals make investments for the purpose of accumulating savings for qualifying higher education costs of beneficiaries.  Section 529 of the Internal Revenue Code also permits the establishment of so-called prepaid tuition plans by states and higher education institutions.  All references herein to “529 plans” are intended to encompass only 529 college savings plans established under Section 529(b)(A)(ii).  In addition, Rule D-12 defines municipal fund security as a municipal security issued by an issuer that, but for the application of Section 2(b) of the Investment Company Act of 1940, would constitute an investment company within the meaning of Section 3 of that Act.  This guidance applies solely to investments in 529 plans, with the exception that the discussion under the heading “Other Sales-Related Activities” below is applicable more broadly to other forms of municipal fund securities as well, such as interests in local government investment pools.  However, no portion of this guidance shall apply to municipal securities other than municipal fund securities.

[2] Rule G-17 Interpretation – Interpretive Notice Regarding Rule G-17, on Disclosure of Material Facts, March 20, 2002See, published in MSRB Rule Book.

[3] Id.

[4] The MSRB observes that most of the traditional centralized established industry sources in the municipal securities market (including but not limited to the NRMSIRs, RTRS and the municipal securities information vendors) are designed specifically for debt securities and do not currently have established methods for making any information they may have with respect to 529 plans readily available to dealers or investors.

[5] As used in this notice, the term “program disclosure document” has the same meaning as official statement under MSRB and SEC rules.

[6] For example, summary information available on the centralized website could have embedded therein direct hyperlinks to the portions of the program disclosure document or other 529 plan materials that provide more detailed descriptions of the summarized information.  In addition, the centralized website could provide hyperlinks to websites, or other contact information for, sources providing performance data current to the most recent month-end, as would be required under the draft amendments to Rule G-21(e)(ii)(C) previously published by the MSRB and soon to be filed with the SEC.  See MSRB Notice 2004-43 (December 16, 2004).

[7] Where a dealer serves as primary distributor for a state’s 529 plan, such dealer is required to contract with the state plan to receive a program disclosure document from the plan that conforms to the minimal standards of Exchange Act Rule 15c2-12.  However, if no broker-dealer is involved in the distribution process for a state’s 529 plan, no requirement exists for the state plan to produce or deliver a disclosure document.

[8] The MSRB recognizes that there are innumerable factors, other than state tax laws, that vary from state to state that can have a positive impact on the economic benefit of a particular investment.  Only those state-based benefits that are specifically targeted toward investments in the state’s own 529 plan are considered valuable benefits to which the requirements enunciated in this notice apply.  For example, a matching grant or scholarship from the state provided only if a customer invests in that state’s 529 plan would be considered a valuable benefit.  On the other hand, a general state law provision that investments or other assets held in a financial institution or issued by an issuer within the state are afforded certain state bankruptcy protections would not give rise to a valuable benefit under this notice, although a law that specifically singles out investments in the state’s 529 plan for such protection would give rise to such a valuable benefit.

[9] Dealers should note that these examples are illustrative and do not limit the circumstances under which, depending on the facts and circumstances, a Rule G-17 violation could occur.

[10] The laws of the 50 jurisdictions that currently offer 529 plans vary greatly and, as a result, no precise definition is provided for what would be considered the customer’s or designated beneficiary’s home state.  Rather, the MSRB would view the term “home state” to encompass any state in whose 529 plan an investment would likely provide the customer or the designated beneficiary with state-based benefits unavailable to investors not having the types of connections with the state as those of the customer or designated beneficiary.  Although legal residence within a state would be presumed to establish such state as a home state, additional states could be considered home states of a particular individual to the extent that the individual is legally able to enjoy state-based benefits that are generally limited to residents of the state.  For example, a customer that is a not a legal resident of a state might, depending on the laws of that state, nonetheless incur tax liabilities within the state that can legally be off-set or avoided by investing in that state’s 529 plan, such as a partner in a multi-state partnership.

[11] Although this suggestion to consult an advisor does not relieve the dealer of any obligations under MSRB rules, including but not limited to those described in this notice, it does serve to emphasize to customers that investments in 529 plans are complex and that customers should seek advice from those who are best positioned to provide it.

[12] The delivery of the program disclosure document to customers pursuant to Rule G-32, which only requires delivery by settlement of the transaction, would be timely for purposes of Rule G-17 only if such delivery is accelerated so that it is received by the customer by no later than the point-of-sale.

[13] Thus, if the program disclosure document contains a series of sections in which the principal disclosures of substantive information on state-tax related consequences of investing in the 529 plan appear, a single inclusion of the required disclosure within, at the beginning or at the end of such series would be satisfactory for purposes of the inclusion with the principal presentation of such other disclosures.  Similarly, if the program disclosure document includes any other series of statements on state-tax related consequences, such as might exist in a summary statement appearing at the beginning of some program disclosure documents, a single prominent reference in the summary statement to the fuller disclosure relating to out-of-state investments appearing elsewhere in the program disclosure document would be satisfactory.

[14] Although it is possible that disclosure to the customer of his or her home state’s state-based benefits could be provided through the program disclosure document of the home state’s 529 plan, such disclosure would be effective only if the discussion included in the program disclosure document describes whether such state-based benefits are also available to an investor who invests in an out-of-state 529 plan.  Furthermore, the dealer would be required to direct the customer’s attention to the specific discussion included in the program disclosure document, rather than to merely provide a copy of the full program disclosure document without such direction.

[15] However, the MSRB notes that Exchange Act Rule 15c2-12(f)(3) defines a “final official statement” as:

a document or set of documents prepared by an issuer of municipal securities or its representatives that is complete as of the date delivered to the Participating Underwriter(s) and that sets forth information concerning the terms of the proposed issue of securities; information, including financial information or operating data, concerning such issuers of municipal securities and those other entities, enterprises, funds, accounts, and other persons material to an evaluation of the Offering; and a description of the undertakings to be provided pursuant to paragraph (b)(5)(i), paragraph (d)(2)(ii), and paragraph (d)(2)(iii) of this section, if applicable, and of any instances in the previous five years in which each person specified pursuant to paragraph (b)(5)(ii) of this section failed to comply, in all material respects, with any previous undertakings in a written contract or agreement specified in paragraph (b)(5)(i) of this section.

Section (b) of that rule requires that the participating underwriter review a “deemed-final” official statement and contract to receive the final official statement from the issuer.  See Rule D-12 Interpretation – Interpretation Relating to Sales of Municipal Fund Securities in the Primary Market, January 18, 2001, published in MSRB Rule Book, for a discussion of the applicability of Exchange Act Rule 15c2-12 to offerings of 529 plans.

[16] The MSRB has previously stated that most situations in which a dealer brings a municipal security to the attention of a customer involve an implicit recommendation of the security to the customer, but determining whether a particular transaction is in fact recommended depends on an analysis of all the relevant facts and circumstances.  See Rule G-19 Interpretive Letter – Recommendations, February 17, 1998, published in MSRB Rule Book.  The MSRB also has provided guidance on recommendations in the context of on-line communications in Rule G-19 Interpretation – Notice Regarding Application of Rule G-19, on Suitability of Recommendations and Transactions, to Online Communications, September 25, 2002, MSRB Rule Book.

[17] Rule G-8(a)(xi)(F) requires that dealers maintain records for each customer of such information about the customer used in making recommendations to the customer.

[18] See Section 529(c)(3) of the Internal Revenue Code.  State tax laws also may result in certain adverse consequences for use of funds other than for educational costs.

[19] The MSRB understands that investors may change designated beneficiaries and therefore amounts in excess of what a single beneficiary could use ultimately might be fully expended by additional beneficiaries.  The MSRB expresses no view as to the applicability of federal tax law to any particular plan of investment and does not interpret its rules to prohibit transactions in furtherance of legitimate tax planning objectives, so long as any recommended transaction is suitable.

[20] If the dealer is authorized to market the customer’s home state 529 plan, it may of course sell such home state 529 plan interests to the customer.  If the dealer is not then authorized to market the customer’s home state 529 plan, it may wish to contact the 529 plan or its primary distributor (if any) to gain such authorization and to sell the home state 529 plan interests to the customer.  The MSRB recognizes that this second option may not always be available, such as where the home state 529 plan is distributed solely through state personnel or through a primary distributor without the use of selling dealers.

[21] The MSRB has previously provided guidance on dealer commissions in Rule G-30 Interpretation – Interpretive Notice on Commissions and Other Charges, Advertisements and Official Statements Relating to Municipal Fund Securities, December 19, 2001, published in MSRB Rule Book.  The MSRB believes that Rule G-30(b), as interpreted in this 2001 guidance, should effectively maintain dealer charges for 529 plan sales at a level consistent with, if not lower than, the sales loads and commissions charged for comparable mutual fund sales.