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News September 10, 2012 Issue

No-Action Relief Permits Advisers to Treat 529 Plans as Pooled Investment Vehicles Under the Custody Rule

Threading the needle between the tax laws and the securities laws can produce some interesting dilemmas, especially when it comes to 529 plans.

The Investment Company Institute (ICI) recently brought one of those issues to the SECís attention, garnering cost-saving relief for both the mutual funds in which the plans typically invest and specifically, the advisers that manage the plans.

529 plans are municipal entities established under the Internal Revenue Code as tax-deferred college savings vehicles. The plans oversee investments primarily in mutual funds over specific time horizons, and permit the tax-free withdrawal of those investments and any earnings provided they are used to pay qualifying higher education expenses.

The plans typically hire an SEC-registered adviser as the program manager, and the adviser in turn contracts with the planís other necessary service providers.

529 plans operate very much like registered investment companies, except that the securities are issued by a state trust. Because those securities are municipal interests, pursuant to Section 2(b) of the Investment Company Act (ICA) the provisions of the ICA do not apply to them.

However, the SEC-registered investment adviser serving as program manager for the 529 plan remains subject to the full range of Advisers Act requirements, including the custody rule.

Although advisers to mutual funds are relieved of the surprise audit requirement as well as the independent verification of assets, advisers to 529 plans are not.

Because the plans are not mutual funds, but their primary investment vehicles are mutual funds, those mutual fund investments are now subject to a surprise audit on the 529 portion of their business, said the ICI.

This is an additional, expensive requirement that results in disparate treatment of 529 plans. A plan with an SEC-registered adviser would be subject to the additional requirement, while a non-adviser program manager, such as a state instrumentality, would not be subject to the additional requirement.

"To avoid this disparate treatment, we seek no-action assurance under Rule 206(4)-2 (as discussed below) that would enable those advisers to 529 plans that are subject to the revised rule and that utilize the services of the fundís custodian in processing 529 plan transactions to rely on the ruleís exception for covered investment pools provided they meet certain conditions set forth below," said the ICI.

The ICI explained its rationale.

529 plans benefit from the expertise offered by service providers experienced in mutual fund operations, such as advisers, transfer agents and custodians. Because 529 plans operate similarly to mutual funds and invest primarily in mutual funds, the additional protections that would be afforded by the revised custody rule are already present. This is why mutual funds were excluded from the amended custody rule requirements.

529 plans resemble pooled investment vehicles, and would appear to qualify for that exception to the custody rule surprise audit requirement, except that the plan has no partners, members, or beneficial owners.

The owner of the trust is the state that created the trust, said the ICI. As a result, a 529 plan may be viewed as ineligible to claim the exemption.

The SEC found the ICIís arguments persuasive, subject to certain conditions ensuring that the additional protections related to mutual funds are present.

The relief was granted in reliance on the following conditions:

  • The 529 plan is a college savings plan;
  • The 529 planís record keeper is an SEC-registered transfer agent;
  • The 529 planís custodian is a "qualified custodian" within the meaning of the custody rule (at Rule 206(4)-2(d)(6));
  • The assets of the 529 plan are subject to annual audits conducted in accordance with GAAS;
  • The audit is conducted by an independent public accountant subject to Public Company Accounting Oversight Board standards and inspection;
  • The audited financial statements of the 529 Plan are prepared in accordance with GAAP;
  • The annual financial statements are provided to the state overseeing the plan within 120 days of the end of the planís fiscal year;
  • The annual financial statements are made available to the 529 planís accountholders through the planís web site; and
  • The adviser will ensure the accountholders are provided with written notification of the availability of the financial statements no later than the delivery of the accountholdersí next quarterly statement.