On August 3, 2009, the Securities and Exchange Commission (the “SEC”) released proposed Rule 206(4)-5 (the “Proposed Rule”), promulgated pursuant to Section 206(4) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”).1 The Proposed Rule is designed to address certain “pay to play” practices of investment advisers seeking to manage funds of state or local government entities.2 The following information summarizes and analyzes the Proposed Rule and its possible effect on investment advisers.

The Proposed Rule

The Proposed Rule seeks to address perceived harms of “pay to play” arrangements by (i) prohibiting an investment adviser and its covered associates3 from (a) providing advisory services to a government entity for compensation for two years after making a contribution to certain government officials4 of such government entity, (b) providing or agreeing to provide, directly or indirectly, payment to any third party for soliciting advisory business from any government entity, and (c) soliciting or coordinating contributions to certain government officials or political parties, and (ii) establishing certain record-keeping requirements relating to an investment adviser’s activities on behalf of any government entity. As discussed in more detail below, however, the Proposed Rule provides for certain exemptions by rule and application.

The Proposed Rule would apply to any investment adviser registered (or required to be registered) with the SEC, or unregistered in reliance on the exemption available under Section 203(b)(3) of the Advisers Act. The Proposed Rule would also apply, with certain limited exceptions, to any investment adviser to a “covered investment pool,” which would include most hedge funds, private equity funds, and venture capital funds, as well as registered investment companies.5

Prohibition on Providing Advisory Services for Compensation

The Proposed Rule prohibits a covered investment adviser from providing advisory services to a government entity for compensation for a period of two years after such adviser, or its covered associates, makes a contribution to certain government officials of such government entity. The Proposed Rule does not create an outright ban on either political contributions or the provision of advisory services to any government entity. Rather, the Proposed Rule imposes a two-year “time out” on receiving compensation for providing advisory business services to a government entity after a covered contribution is made.

Prohibition on Solicitations of Government Business

The Proposed Rule prohibits a covered investment adviser and its covered associates from providing, or agreeing to provide, directly or indirectly, payment to any third party for soliciting advisory business from any government entity on behalf of such investment adviser. The prohibition applies to third-party finders, solicitors, placement agents, or pension consultants who solicit government entities for investment advisory services, but not to any “related person”6 (or employees of such related person if the related person is a “company”) of a covered investment adviser or any executive officer or partner of the covered investment adviser. “The related persons,” executive officers, or partners of a covered investment adviser could, however, trigger the two-year ban on compensation discussed above if any of them provided a contribution to a relevant government official.

Prohibition on Soliciting and Coordinating Contributions

The Proposed Rule also prohibits a covered investment adviser and its covered associates from soliciting from others, or coordinating, contributions to any government official of a government entity, where such investment adviser is providing or seeking to provide advisory services to such government entity. The restriction includes activities where an investment adviser bundles funds of several different persons or entities together and acts as a gatekeeper to contribute such funds to a government official.

Exemptions to the Proposed Rule

The Proposed Rule provides two exemptions for cases where the SEC believes the risk for “pay to play” activities is low. First, there is an exemption for any contribution or series of contributions by a covered associate, totaling $250 or less per election, to a candidate for whom the contributing person is entitled to vote. Second, contributions made by covered associates to government officials for whom the covered associate is not entitled to vote at the time of the contributions are also exempted if (i) the contributions do not exceed $250 in the aggregate to any one government official, per election, (ii) the investment adviser discovered the contributions within four months of the date of any contribution, and (iii) within sixty days of learning of any such contribution, such investment adviser caused the contribution to be returned to the contributor.

The Proposed Rule also permits a covered investment adviser to apply to the SEC for an order exempting the covered adviser from the two-year compensation ban. A covered investment adviser may submit such an application where such investment adviser discovers contributions that trigger the compensation ban after they have been made, or when imposition of the “time out” is deemed unnecessary to achieve the Proposed Rule’s intended purpose. In determining whether to grant an exemption from the two-year compensation ban, the SEC stated that it would make such determination based upon the particular facts and circumstances that each application presents.


The Proposed Rule contains proposed amendments to the record-keeping requirements of Rule 204-2 under the Advisers Act. Specifically, such amendments would require an investment adviser that is (i) registered or required to be registered as an investment adviser with the SEC and (ii) (a) seeks or currently has government clients, or (b) provides advisory services to a “covered investment pool” in which a government entity invests or is solicited to invest, to maintain certain records relating to contributions made by such investment adviser or its covered associates. Notably, while the prohibitions established by the Proposed Rule expressly cover investment advisers that rely on the exemption from investment adviser registration provided by Section 203(b)(3) of the Advisers Act, Rule 204-2 applies only to investment advisers that are registered or required to be registered under the Advisers Act.

Analysis and Next Steps

Citing certain recent regulatory and criminal actions involving alleged “pay to play” arrangements between investment advisers and government entities, the SEC’s commentary accompanying the Proposed Rule notes that a primary concern of the SEC is the potential harm that “pay to play” arrangements could have to clients of a relevant investment adviser and participants in a relevant government investment plan. The concept of limiting “pay to play” arrangements, however, is not new to regulators governing the investment industry. For example, as the SEC notes, the Proposed Rule is modeled on rules G-37 and G-38 of the Municipal Securities Rulemaking Board, (the “MSRB”) which address “pay to play” practices in the municipal securities markets. In addition, certain state and local regulators have also recently pushed for, and in some cases obtained, more stringent regulations relating to “pay to play” practices.

If enacted, the Proposed Rule would impose heightened compliance and procedural requirements on investment advisers, including unregistered advisers to pooled investment vehicles, that currently have, currently solicit, or that plan to solicit government clients/investors. If a covered investment adviser is not doing so already, it will need to implement procedures designed to limit, monitor (or otherwise track), analyze and/or appropriately address relevant political contributions (whether intentional or unintentional), while avoiding over-reaching procedures that could violate an employee’s constitutional rights or otherwise run afoul of applicable laws, rules and regulations. Unregistered investment advisers, in particular, may face increased compliance costs associated with the Proposed Rule. The costs associated with compliance, however, may differ substantially among advisory firms depending upon the size of the firm and the firm’s policies and procedures currently in place. The costs associated with compliance may also vary based upon the covered adviser’s affiliated operations. For example, as the SEC speculates in the commentary to the Proposed Rule, covered investment advisers may be able to take advantage of the existing compliance structure of affiliated broker-dealers that are already subject to similar political contribution requirements imposed by the MSRB.

The SEC is accepting comments on the Proposed Rule until October 6, 2009. As a result, covered investment advisers have time to voice their concerns with respect to the Proposed Rule and/or to prepare for the eventual passage of the Proposed Rule. Investment management firms are well advised to take the initiative now to contact industry groups that may comment on the Proposed Rule, and to review their existing policies, operations and resources in order to highlight potential areas of concern in the event that the Proposed Rule is enacted in its current form.