With the record-breaking campaign expenditures[1] of the 2014 midterm elections behind us, and the 2016 campaign cycle already heating up, this is an ideal moment for investment advisers (including advisers to venture capital funds and certain private equity and hedge funds) to ensure that they have mechanisms in place to verify compliance with the U.S. Securities and Exchange Commission’s pay-to-play rule.[2] The SEC has ramped up enforcement of the rule: the first case charged under the rule settled last year,[3] and the director of the SEC’s Division of Enforcement has declared it to be a current priority.[4]

The rule, which is intended to prevent investment advisers from using campaign contributions to exert improper influence over existing and prospective investments by public sector clients (e.g., pension funds), carries potentially significant consequences for even small-dollar violations made without any intent to influence a current or potential investor.[5] For example, in the first charges brought under the rule, an adviser faced the loss of over $250,000 in fees earned over two years from two clients — a state pension fund and a city pension fund — and a $35,000 fine, all because of less than $5,000 in campaign contributions made by a co-founder of the fund to candidates for state and municipal office.[6]

Because the rule covers even very small donations, does not require any improper intent, and bars advisers from receiving any compensation from a government entity client, even a single

$200 donation by an employee of an adviser to an unsuccessful candidate for office could violate the rule and require the adviser to forgo hundreds of thousands, if not millions, of dollars in compensation from a government entity client for two years.[7]

While the rule sweeps broadly and imposes substantial consequences, the SEC has granted applications for exemptions where advisers have demonstrated that they had appropriate policies and procedures in place to comply with the rule, that improper contributions were promptly identified, and that employees who made such contributions were unaware they would violate the rule.

In particular, in the three instances where the SEC has issued an exemptive order to an adviser, the adviser had compliance procedures in place requiring pre-clearance of political contributions, the contributor was able to establish that he did not intend to influence a government entity’s selection of an investment adviser and did not realize the contribution would violate the rule, and on learning of the contribution, the adviser promptly responded by placing fees from the relevant client in escrow and ensuring the contributor requested a refund of the contribution.[8]

Notably, two of the orders cover contributions made to candidates’ campaigns for federal office where the recipient candidates held state or local office at the time the contribution was made, highlighting an easy to miss aspect of the rule: the rule applies equally to contributions to candidates who in their current position have influence over a state or local pension fund (even if they are running for federal office), as it does to contributions to a candidate who, if elected, would have influence over a state or local pension fund.

Given the breadth of contributions covered under the rule, advisers should consider policies and procedures even broader than the rule, such as:

Implementing policies and procedures that include pre-clearance of all political contributions;

Including the rule in annual compliance training and certification processes for employees, partners and others whose role at the adviser makes them subject to the rule; and

Conducting periodic checks of contributions made by covered associates in jurisdictions where the adviser has government-entity clients by searching publicly available contribution disclosure databases.

Although burdensome, such policies can help prevent, or at least identify and address, contributions that require advisers to forgo payment for advisory services to public pension funds and other government-entity clients.

While the constitutionality of the rule is currently being challenged in federal court, the outcome and timing of that litigation are uncertain, and thus advisers must continue to comply with the rule for now.[9] Given enhanced press attention to the role of contributions in elections, and some recent high-profile pay-to-play settlements, we expect the SEC will continue active enforcement of the rule while also issuing exemptions in appropriate circumstances.

Additional Background on the Rule

The rule applies to all investment advisers registered (or required to be registered) with the SEC, as well as exempt reporting investment advisers.[10] The rule prohibits investment advisers from receiving compensation for advisory services provided to a government entity[11] for two years after a contribution to an official or a candidate to be an official of that government entity[12] is made by the investment adviser or a covered associate of the adviser.[13] As discussed above, although the rule’s prohibitions apply only to adviser clients that are state and local government entities, contributions to a candidate for federal office still violate the rule if, at the time of the contribution, the candidate holds a state or local office with influence hiring an investment adviser.[14]

There are limited exceptions, in particular, low-dollar contributions by a covered associate (up to $350 per election if they are entitled to vote for the recipient candidate, and up to $150 if they are not).[15] Additionally, an adviser may “cure” a violation due to a contribution of $350 or less by a covered associate if the contribution is identified within four months and a return of the contribution is obtained within 60 days of discovery by the adviser.[16]

As discussed above, if a violation occurs, an adviser may apply to the SEC for an exemption.[17] There are substantial costs in applying for an exemption and a high degree of uncertainty as to success, however, so fashioning strong compliance procedures should be a high priority.