More than any other election cycle since the Securities and Exchange Commission (SEC) pay-to-play rule for investment advisers (Rule 206(4)-5) became effective in 2011, the 2016 elections are likely to pose significant compliance challenges for investment advisers and exempt reporting advisers subject to the Rule. Presidential aspirants are already raising historic sums through an increasingly varied set of fundraising vehicles and non-profit entities, and many individuals in the financial services sector are regularly being solicited to make political contributions. While Rule 206(4)-5 has a number of distinct elements, the core of the Rule is the “Two-Year Ban” – a provision that prohibits registered investment advisers and exempt reporting advisers (covered advisers) from receiving compensation for providing investment advisory services to a state or local government entity for two years if the adviser or certain of its employees (covered associates) makes a non-de minimis political contribution to specific candidates or officials associated with the government entity in question. If a covered adviser is providing investment advice to a government entity – either directly or by acting as an adviser to a pooled investment vehicle in which the government entity is an investor – the Two-Year Ban would prohibit the adviser from receiving compensation for providing investment advisory services in connection with that investment unless the adviser obtains exemptive relief from the SEC. The pay-to-play compliance challenges for covered advisers are heightened by a number of notable trends and features of the 2016 election cycle. As an initial matter, the 2016 presidential elections will potentially involve more “covered officials” – essentially, candidates covered by Rule 206(4)-5 – than ever before. A presidential candidate only can be a covered official if he or she is a state or local officeholder at the time of the presidential campaign, and this year the ranks of “covered officials” running for President potentially will include Wisconsin Governor Scott Walker, New Jersey Governor Chris Christie, Ohio Governor John Kasich, and Louisiana Governor Bobby Jindal, among others. In addition, the 2016 election cycle has been marked by a proliferation of new campaign-related vehicles and giving patterns. As a result of recent Supreme Court decisions and other factors, potential donors are being asked to give to Super PACs, joint fundraising committees, special political party funds and accounts, and 527 or 501(c)(4) organizations. Many of these organizations, in turn, contribute to or have relationships with “covered officials.” The application of Rule 206(4)-5 to these vehicles can be complex, and donors may not fully realize the consequences of donating to such entities or how to mitigate associated pay-to-play examination and enforcement risks. In a recent article published in the Investment Lawyer (link below), Charles Borden, Samuel Brown and Claire Rajan provide an overview of the state of play on Rule 206(4)-5 compliance for the 2016 election cycle, with a particular focus on the SEC’s treatment of exemptive relief applications. They also provide covered advisers with concrete compliance recommendations, with a focus on steps to take both when designing a compliance program and when responding to a potential Rule 206(4)-5 violation.
Essential Components of a Pay-to-Play Compliance Program
- Pre-clearance policies for political contributions by covered associates, and a system for establishing who should be subject to such policies;
- Regular notifications and trainings for covered associates on the need to seek and obtain pre-clearance;
- Periodic certifications by covered associates confirming that they have complied with pre-clearance policies and reporting any contributions made in violation of such policies;
- Regular testing and monitoring by Legal and Compliance personnel to ensure compliance with such policies and detect any violations; and
- Recordkeeping procedures with regard to each of the foregoing.
Steps to Take If You Suspect a Violation of Rule 206(4)-5
- Conduct an internal review to determine whether the elements of the two-year ban are satisfied. During the review, ensure that the potential covered associate does not solicit the government entity investor in question.
- Promptly seek reimbursement of the contribution.
- Establish an escrow fund to hold all advisory fees received from the government entity as soon as possible after discovering the violation. Consider whether to notify government entity investors of the potential violation and the existence of the escrow fund.
- Limit the channels of communication between the government entity investor and the covered associate who made the contribution, and carefully document compliance with such limits.
- Consider whether there was a breakdown in the compliance program and conduct a compliance review (internally or utilize outside counsel) and move swiftly to address any gaps in the compliance program.