On August 31, 2012, the Securities and Exchange Commission’s (the SEC) Office of Compliance Inspections and Examinations (OCIE) issued a National Examination Risk Alert (the Risk Alert) that made clear that OCIE has some significant concerns about firms’ compliance with Municipal Securities Rulemaking Board (MSRB) Rule G-37, the so-called “Pay-to-Play” rule. MSRB Rule G-37 prohibits firms and certain associated individuals from contributing to the political campaigns of public officials of municipal issuers when the firm is engaged in municipal securities business with the issuer or seeking such an engagement.
While the primary focus of the OCIE Risk Alert is on compliance with MSRB Rule G-37, the SEC’s observations are also instructive in evaluating how the compliance programs of private equity and hedge funds (investment funds) might address “Payto- Play” rules in general, including SEC Rule 206(4)-5, the New York Attorney General’s Public Pension Fund Reform Code of Conduct (the “Code of Conduct”) and myriad other potentially applicable state and local provisions. In fact, MSRB Rule G-37 has been used as the model for most “Pay-to-Play” rules throughout the country.
Given mandatory investment fund registration under Dodd-Frank, and the SEC inspection regime that goes along with it, investment funds should take the SEC’s guidance as a clear warning that they should conduct a comprehensive review of their “Pay-to-Play” compliance programs while keeping the SEC’s “observations” in mind. In fact, the SEC’s guidance is helpful in suggesting various measures that investment funds might consider implementing including: (1) pre-clearance of contributions; (2) surveillance; (3) self-certification; (4) training; and (5) enhanced record keeping.
Investment funds should not miss this opportunity to evaluate their “Pay-to-Play” compliance. It is clear that the SEC has “Pay-to-Play” practices in its crosshairs and it would not be surprising if the Risk Alert foreshadows enforcement actions in the near future.
MSRB Rule G-37 and Applicability of the Risk Alert to Other “Pay-to-Play” Rules
MSRB Rule G-37 prohibits brokers, dealers or municipal securities dealers (“firms”) from engaging “in municipal securities business with an issuer within two years after any contribution to an official of such issuer” that is made by (1) the firm, (2) a “municipal finance professional” (MFP)1 associated with the firm; or (3) a political action committee controlled by the firm or MFP.2 In other words, if a prohibited contribution is made, the firm is banned from engaging in any municipal securities business with that particular issuer during the two year period.3 Rule G-37 also contains certain recordkeeping and disclosure provisions. In general, covered firms must file a Form G-37 quarterly with the MSRB. Form G-37 must include information identifying (1) the issuers that the firm engaged in municipal securities business with during the reporting period; (2) the campaign contribution amounts made by the firm, each MFP, each non-MFP executive officer and each political action committee controlled by the firm or any MFP; and (3) the name and title of each issuer official receiving such contributions.4
While the SEC specifically limits its Risk Alert guidance to firms in municipal securities business regulated by MSRB Rule G-37, its guidance is instructive in evaluating investment fund compliance with the myriad of other applicable federal, state and local “Pay-to-Play” rules. For example, SEC Rule 206(4)-5 generally prohibits an investment adviser from receiving compensation from a government entity in exchange for investment advisory services within two years of the adviser or a “covered associate” making a contribution to an official of the government entity.5 The rule also prohibits an investment adviser from paying third parties to solicit a government entity for investment advisory services unless such person is “regulated” and subject to the “Pay-to-Play” restrictions.6 In connection with SEC Rule 206(4)-5, and similar to MSRB Rule G-37, registered investment advisers that have government entities as clients must keep records of contributions made by the adviser and covered associates to government officials, candidates, PACs and state or local parties.7
Similarly, the New York Attorney General’s Office has made the elimination of “Pay-to-Play” practices a priority. In 2009, then Attorney-General Andrew Cuomo issued the Public Pension Fund Reform Code of Conduct which prohibits investment firms (as well as any related parties including employees) from accepting, managing or retaining an investment from, or providing investment management services to a public pension fund within two years after the firm or any related party makes a contribution to an official who can influence the fund’s decisions.8 Firms who sign onto the Code of Conduct (which has included several prominent private equity firms) must adopt written internal procedures to ensure compliance with the contribution prohibitions in the Code of Conduct and must certify compliance with the Code’s provisions on an annual basis to the New York Attorney General’s office.9 The Code of Conduct also contains a number of detailed provisions that require investment firms to disclose information prior to the closing of an investment or an engagement to provide investment management services to a public pension fund. Notably, these disclosure provisions concern not just contributions that would be prohibited under the Code, but also a much more broad set of contributions to political parties, state or county political committees, and candidates for state or federal elected office.10
At their core, SEC Rule 206(4)-5 and the Code of Conduct are similar to MSRB Rule G-37 by restricting the same basic conduct—making political contributions to a government official when a firm is engaged in business with, or seeking an engagement from, government agencies that such an official may influence. Therefore, investment funds should pay close attention to the SEC’s guidance regarding compliance with MSRB Rule G-37.
Examination Observations: Issues with Compliance
The Risk Alert explains that in conducting recent National Examination Program (NEP) examinations, the OCIE staff observed a number of practices that raised “concerns about firms’ compliance with their obligations” under Rule G-37 and other related rules.11
First, the OCIE staff observed that some firms may have engaged in municipal securities business in violation of Rule G-37 because of political contributions made by employees to issuer officials within the prohibited time periods.12 Second, the OCIE staff observed that some firms may not have kept accurate records identifying their MFP employees and non-MFP executive officers.13 Such records are required by MSRB rules and are necessary to adequately ensure compliance with Rule G-37. Third, the OCIE staff observed that some firms may have filed inaccurate and incomplete G-37 forms including by omitting municipal securities business that a firm was engaged in and failing to provide all political contributions made by MFPs to issuer officials.14 Fourth, the OCIE staff observed that some firms may have failed to establish or implement adequate supervisory procedures to ensure compliance with Rule G-37.15 In particular, the Risk Alert cautions that, “[o]nce a firm has designed procedures to ensure compliance with the rules, it must also implement those procedures.”16
While the Risk Alert uses carefully crafted language to avoid stating that firms have definitely violated the “Pay-to-Play” rules or even that the problems are widespread, the message behind the staff’s observations is clear: the SEC is closely examining violations of the “Pay-to-Play” rules and has reason to be skeptical that firms are consistently complying with the rules’ prohibitions. Given the problems observed by the SEC with regard to compliance with the “Pay-to-Play” provisions of MSRB Rule G-37, it is highly likely that investment funds will face the same sort of scrutiny from the SEC as brokers and dealers in the municipal securities business during their inspections.
SEC Guidance: Steps Firms Should Consider in Evaluating Compliance
Without committing to any particular compliance regime as adequate or appropriate, the Risk Alert does include some guidance on compliance measures that the staff clearly believes should be considered by member firms in evaluating their current “Pay-to-Play” compliance programs. The measures identified by the SEC in the Risk Alert include:
- Training: Many firms provide training for MFPs on the MSRB “Pay-to-Play” rules and document this training. The Risk Alert notes that the “training serves as an important supplement to surveillance, particularly during years in which political contributions are likely to be higher, such as presidential election years.”
- Self-Certification: Some firms require MFPs and employees who may become MFPs to certify annually or periodically that they are complying with all firm requirements concerning political contributions.
- Surveillance: Some firms use various resources including the internet to search public records to monitor political contributions and determine whether such contributions are being reported on the firm’s Form G-37. Firms may also screen e-mail and other communications to determine whether political contributions are being made.
- Two Year Look-back Procedures: Some firms have implemented procedures to identify individuals who may become MFPs due to a promotion or a change in duties which would then trigger Rule G-37 applicability. Some firms have made these individuals subject to the political contribution rules for MFPs prior to any such changes.
- Pre-Clearance of Political Contributions: Some firms require prior approval from the compliance department for political contributions made by MFPs, and in some circumstances prior approval of contributions made by even non-MFPs.
- Prohibition on Political Contributions: Some firms have prohibited any non-de minimis political contributions to the extent allowed by state or local law.
- Separation of Functions: Some firms have implemented a separation between functions such as pre-clearance and surveillance, on the one hand, and management on the other hand, in order to protect against any adverse action arising out of an employee’s political contributions.17
The Risk Alert cautions that “it does not purport to provide a list of steps to effectively discharge responsibilities,” but certainly the fact that the SEC has identified these potential measures means that investment funds should consider the measures to be valuable guidance in evaluating “Pay-to-Play” compliance programs.18
Should a pre-clearance system be implemented? Should changes be made to the investment fund’s record keeping procedures? Should the fund employ surveillance including the possibility of monitoring contributions via publicly available internet sites? While not every policy or procedure identified by the SEC in the Risk Alert is necessary or even appropriate for a particular fund, it would be prudent to begin an evaluation of “Pay-to-Play” compliance programs with these measures in mind.
The key question investment funds must ponder is whether they have sufficient compliance policies and procedures in place when faced with the inevitable SEC inspection, or whether the SEC will find the same sorts of potential violations as during its recent MSRB Rule G-37 reviews. This question is even more germane given the fact that under the new Dodd-Frank regulatory regime, many more investment funds will be subject to their first inspection.19 It would therefore behoove investment funds to conduct a comprehensive review of their recordkeeping and “Pay-to-Play” compliance programs well in advance of any inspection so that they may take action before it’s too late. The SEC has provided invaluable guidance on “Pay-to-Play” compliance and investment funds should seize this opportunity.
The Risk Alert is a valuable chance to gain insight into the SEC’s thoughts on the compliance of firms with not just MSRB Rule G-37, but the myriad of other “Pay-to- Play” rules that may be applicable. The Risk Alert raises a number of issues that the legal and compliance departments of investment funds affected by “Pay-to-Play” rules should strongly consider.
First, it is clear that the SEC is focusing on potential “Pay-to-Play” violations during its NEP inspections and it would not be surprising if the Risk Alert is a harbinger of enforcement actions in the near future, especially with elections less than two months away. Investment funds should recognize that “Pay-to-Play” violations are a priority for the SEC and funds should consider evaluating potential weak spots in their “Pay-to-Play” compliance programs. Investment funds, particularly those facing an OCIE inspection for the first time, should strongly consider conducting a comprehensive review of their “Pay-to-Play” compliance programs and recordkeeping well in advance of any inspection. Second, the SEC’s “observations” provide valuable guidance regarding measures that investment funds should consider in structuring or evaluating their compliance with “Pay-to-Play” rules.
Finally, all investment funds are different and there is no uniform checklist or list of procedures that would be appropriate to implement for every fund. Legal and compliance departments should consider the SEC’s guidance, but realize that an appropriate compliance system for “Pay-to-Play” rules often must be customized based upon a myriad of factors which may include the size of the fund, the additional state and local laws at play and a determination of the most efficient and cost effective way to implement an effective compliance system. Once that evaluation takes place investment funds can feel secure that they are complying with “Pay-to-Play” rules when NEP examiners come knocking.