The US Securities and Exchange Commission (SEC) recently took action to curb pay-to-play abuses with respect to investment advisory services for any “plan or program of a government entity”; essentially, any state or local pension funds, retirement systems or other government plans (all referred to herein as government plans). On June 30, 2010, the SEC adopted Rule 206(4)-5 (the Rule) under the Investment Advisers Act of 1940 (Advisers Act),1 which had been under consideration for the past year. Investment advisers are cautioned that the Rule does not preempt current or future state or local restrictions on similar activities. As a result, in addition to complying with the Rule, investment advisers should confirm whether other state or local restrictions apply to each government plan investment.2
The SEC Rule
The Rule, which is modeled after Rules G-37 and G-38 of the Municipal Securities Rulemaking Board (MSRB), aims to curb pay-to-play abuses with respect to government plans by restricting the use of third-party placement agents in soliciting government plans for advisory business and by imposing limitations on certain campaign contributions. The Rule applies to every investment adviser registered (or required to be registered) with the SEC, as well as to unregistered advisers providing advice to private funds exempt from registration under certain provisions of the Investment Company Act.3 The Rule expressly prohibits doing indirectly that which it directly prohibits, and compliance with the Rule is subject to a strict liability standard, rather than then usual standard of reasonable behavior.
The Rule takes effect on September 13, 2010, and, except as noted below, investment advisers must be in compliance by March 14, 2011. The Rule’s prohibition on making certain political contributions and soliciting or coordinating political contributions, including the two-year look-back described below, will not take into consideration contributions made before March 14, 2011.4
SEC Restriction on Use of Placement Agents
The Rule makes it unlawful for any covered investment adviser, or any of the adviser’s covered associates, to provide or agree to provide, directly or indirectly, payment to any third party (including “finders,” “solicitors,” “placement agents” or “pension consultants”) to solicit a government plan for investment advisory services, unless the third party is a “regulated person.” The SEC had previously considered a complete prohibition on the use of placement agents, but instead opted for this less restrictive approach.
Regulated persons include any registered broker-dealer or registered investment adviser. At the request of the SEC, the Financial Industry Regulatory Authority (FINRA), which is an independent regulator of broker-dealers, has agreed to adopt similar campaign contribution restrictions. Consequently, regulated persons capable of serving as third-party placement agents will be subject to the same or similar campaign contribution restrictions as those described below. The restriction on the use of third parties does not take effect until September 13, 2011, in order to allow FINRA to adopt its own rule.5
Restrictions on Campaign Contributions
The Rule makes it unlawful for advisers to receive compensation for providing advisory services to a government plan for a two-year period (the two-year “time out”) after the adviser or any of its covered associates makes a political contribution to certain public officials. The term “official” is defined to mean incumbents serving in public offices who are directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by the government plan, or who have authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by the government plan. It also includes candidates for such offices and such candidates’ election committees. Whether or not an office is subject to the Rule is a factual determination to be made on a case-by-case basis upon a review of state and local law. Although not directly applicable to federal campaigns, the Rule does not completely exempt contributions to federal campaigns. Contributions are prohibited to candidates for federal office who are, at the time of the contribution, also a state or local official otherwise subject to the prohibition.
The Rule also prohibits an investment adviser or its covered associates from soliciting or coordinating contributions to a public official of a government entity to which the adviser is providing or seeking to provide investment advisory services, or to a political party of the state or locality where the adviser is providing or seeking to provide investment advisory services.
The term “covered associates” includes general partners, managing members, certain executive officers and policy-making persons, as well as any employee of the adviser who solicits government plan clients for the investment adviser or supervises such persons. The term also includes any PAC controlled by the adviser or its other covered associates.
The term “contribution” is defined quite broadly and includes (i) making any gift, subscription, loan, advance, or deposit of money or anything of value for the purpose of influencing any election for federal, state or local office; (ii) paying debt incurred in connection with any such election; or (iii) paying transition or inaugural expenses of the successful candidate for state or local office. While the Rule does not specifically prohibit contributions by the adviser or its covered associates to a political party or other political action committees (PACs), it prohibits doing indirectly anything that, if done directly, would violate the Rule. Therefore, contributions to political parties and PACs may be effectively restricted in certain situations based upon the intent of the contributor and the facts and circumstances of the contribution.
The two-year time out will continue to apply to the adviser itself even after a covered associate who made a triggering contribution has ceased employment. Additionally, contributions made by a covered associate will be attributed to any other adviser that employs or engages the covered associate within two years after the date of the contribution. The employing adviser must look back in time to determine whether hiring such a formerly covered associate would subject the adviser to any business restrictions under the Rule. However, the adviser is only required to look back for a period of six months if the former covered associate made the contribution more than six months earlier and does not solicit clients on behalf of the adviser after becoming an employee of the adviser.
The two-year time out is applicable only to contributions made by the adviser and the adviser’s covered associates and applies only to compensated advisory services such that an adviser could still provide uncompensated advisory services to a government plan after making an improper contribution. In fact, an adviser may be required to provide services free of charge for a reasonable period of time to ensure that the government plan can identify a sufficient replacement.
The Rule also treats investment advisers to certain pooled investment vehicles in which a government plan invests, or is solicited to invest, as though the adviser were providing or seeking to provide investment advisory services directly to the government plan. As such, the two-year time out applies to any solicitation activities directed at such investors. The SEC provided an extended compliance date of one year, or as of September 13, 2011, from the effective date to give such advisers time to identify any government plans invested in pooled vehicles they manage. Advisers to registered investment companies that have shares sold by brokerdealers through omnibus accounts may have an especially difficult time determining whether any fund shareholders are government plans. However, in the context of registered investment companies, only those government plans that are participant-directed are required to be identified.
Individuals otherwise covered by the Rule are permitted to make de minimis contributions in an aggregate amount of $350 or less, per election, to an elected official or candidate for whom the person making the contribution is entitled to vote; and $150 or less, per election, to an elected official or candidate for whom the person making the contribution is not entitled to vote. Certain other inadvertent prohibited contributions may be exempted from the prohibition if the adviser takes specific remedial steps. Additionally, an adviser may seek a specific exemption from the SEC for any prohibited contribution.
To facilitate compliance with the Rule, the SEC also adopted a corresponding amendment to Rule 204-2 of the Advisers Act that requires covered investment advisers doing business with or seeking to do business with government plans to keep certain records of contributions and payments made by the adviser and its covered associates.
Except as otherwise specifically noted, the Rule requires an adviser to maintain the following records no later than March 14, 2011:
- The names, titles and business and residential addresses of all covered associates of the investment adviser;
- All government entities to which the investment adviser provides or has provided investment advisory services, or which are or were investors in any covered investment pool to which the investment adviser provides or has provided investment advisory services, as applicable, in the past five years (but not prior to September 13, 2010);
- All direct or indirect contributions made by the investment adviser or any of its covered associates to an official of a government entity, or direct or indirect payments to a political party of a state or political subdivision thereof, or to a political action committee; and
- The name and business address of each regulated person to whom the investment adviser provides or agrees to provide, directly or indirectly, payment to solicit a government entity for investment advisory services on its behalf.
The records of contributions and payments must be kept in chronological order, identifying each contributor and recipient, the amounts and dates of each contribution or payment, and whether the contribution or payment was subject to the exemption for certain returned contributions pursuant to the Rule. These records must be maintained in the same manner, and for the same period of time, as most other books and records under Rule 204-2. However, advisers who are already making and keeping records required under the Securities Exchange Act of 1934, or to satisfy Rules G-37 or G-38 of the MSRB, which are substantially similar to records required by the Rule, may rely on their existing recordkeeping processes for such records.