Recent actions by financial industry regulators, including the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority, Inc. (“FINRA”), and the Municipal Securities Rulemaking Board (“MSRB”), reflect a continuing focus on political contributions. The SEC recently announced settlements with ten investment advisory firms under its pay-to-play rule, imposing penalties for what appear to be relatively minor violations. In the case of broker-dealers and municipal advisers, the SEC also approved FINRA’s new pay-to-play rule and permitted an expansion of the MSRB pay-to-play rule to take effect.
SEC Pay-to-play Sweep Settlements
The SEC announced settlements with ten investment advisory firms, on January 17, 2017, that violated the SEC pay-to-play rule, Rule 206(4)-5, promulgated under the Investment Advisers Act of 1940, by accepting fees from public pension funds following campaign contributions by “covered associates” (as defined in the rule and explained below) above the applicable de minimis contribution limits. The firms paid penalties ranging from US$35,000 to US$100,000 as a result of contributions ranging from US$400 to US$10,000, and the SEC imposed censures and cease-and-desist orders against each of the firms.
Rule 206(4)-5 was adopted by the SEC in 2010 in the wake of corruption scandals involving public pension plans. The rule prohibits investment advisers from providing advisory services for compensation to a government entity for two years after the adviser or any of its “covered associates” makes a political contribution to an “official” of that government entity. “Official” is defined to include “any person, including any election committee for the person, who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office” can influence the selection of an investment adviser. “Covered associate” is defined as “i) any general partner, managing member or executive officer, or other individual with a similar status or function; ii) any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and iii) any political action committee controlled by the investment adviser or [a covered associate].” Rule 206(4)-5 also prohibits investment advisers from coordinating or soliciting third-party contributions to government entity officials.
Announcing the sweep, LeeAnn Ghazil Gaunt, Chief of the SEC Enforcement Division’s Public Finance Abuse Unit, stated: “The two-year timeout is intended to discourage pay-to-play practices in the investment of public money, including public pension funds. Advisory firms must be mindful of the restrictions that can arise from campaign contributions made by their associates.”
The SEC did not allege that the violations at issue involved corrupt intent or scienter and the orders contain no assertion that the political contributions were made with intent to influence a government entity’s decision to hire the investment adviser. The amounts of the contributions at issue were relatively small; only two of the contributions were above US$1,500. Six of the contributions were returned by the candidate or campaign to the covered associate. However, even under these circumstances, the SEC found that each of the ten advisory firms “willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-5 thereunder.”1 The SEC brought these proceedings under Section 203(e) of the Investment Advisers Act of 1940, which allows for censure for willful conduct, as well as Section 203(k), which provides for the less severe imposition of cease and desist orders. Because the orders included the willful violation as well as Section 203(e), the ten firms are potentially subject to collateral consequences under several securities laws and regulations thereunder, in addition to the penalties imposed by the SEC. See, e.g., 17 C.F.R. § 230.405; 15 U.S.C. § 80a-9(a),(b); 17 C.F.R. § 275.206(4)-3(a); 17 C.F.R. § 230.506.
Of note, one of the settling firms was fined US$35,000 for a single US$500 contribution by a covered associate to the Treasurer of Massachusetts that was returned to the covered associate. Another firm was fined the same amount for a US$400 contribution by a covered associate to a candidate for the Mayor of New York City. A third firm was fined US$75,000 for a US$500 contribution by a covered associate to a candidate for Governor of Massachusetts that was also returned. The highest penalty, US$100,000, was imposed based on four contributions by a covered associate to two different candidates for Mayor of New York City totaling US$1,925. The highest contribution at issue was a US$10,000 contribution to a candidate for Governor of Wisconsin. That firm was fined US$75,000.
It is clear that the fines do not directly correlate with the amount of the contribution. Although the amount of fees each adviser received during the two years following the contributions was not disclosed in the orders, it appears that the SEC took the fees received – or other facts not disclosed in the orders - into account in determining the fines. The SEC did not, however, require disgorgement of the fees.
These settlements emphasize the strict liability nature of the SEC rule and the SEC’s willingness, at least under the prior administration, to pursue enforcement actions even for relatively minor violations where there is no suggestion of actual corruption.
Approval of FINRA Pay-to-play Rules
On August 25, 2016, the SEC approved pay-to-play rules proposed by FINRA. See Release No. 34-78683. FINRA Rules 2030 and 4580 will become effective, as proposed, on August 20, 2017. See FINRA Regulatory Notice 16-40. Dechert’s January 2016 OnPoint discussed the FINRA pay to play rules in detail.
FINRA Rule 2030 closely follows Rule 206(4)-5 and applies to political contributions by FINRA member firms that, for compensation, engage in distribution or solicitation activities with government entities on behalf of certain investment advisers. FINRA Rule 4580 imposes certain related books and records requirements. See Release No. 34-76767.
Further, on September 20, 2016, the SEC issued an order that Rule 2030 “imposes substantially equivalent or more stringent restrictions on brokers-dealers than rule 206(4)-5.” See Release No. IA-4532. Rule 206(4)-5 prohibits an investment adviser from making payments to a third-party for soliciting government entities unless the third party is subject to a “substantially equivalent” rule regarding political contributions, although this provision’s effective date was long delayed. Accordingly, the SEC has determined that FINRA members (and MSRB members, see below) are now subject to a “substantially equivalent” rule, which means that investment advisers may pay FINRA (and MSRB) members for soliciting government entities.
MSRB Revised Pay-to-play Rules
The MSRB also recently revised its pay-to-play rules, G-37, G-8, and G-9, which were automatically deemed effective by the SEC on February 13, 2016, pursuant to Rule 19b-4 under the Securities Exchange Act of 1934, and became effective on August 17, 2016. MSRB Regulatory Notice 2016-06. Revised Rule G-37 extended the MSRB pay-to-play rule to municipal advisers, while revised Rules G-8 and G-9 applied the previous MSRB books and records rules to those same firms. See Release No. 34-76763. Prior to their amendment, the MSRB pay-to-play rules only applied to brokers, dealers, and municipal securities dealers. On September 20, 2016, the SEC issued an order finding that rule G-37 “imposes substantially equivalent or more stringent restrictions on municipal advisors than rule 206(4)-5.” See Release No. IA-4531.
The Republican Parties of Georgia, New York and Tennessee filed an action in federal court challenging the revisions to the MSRB rules. Tennessee Republican Party et al., v. SEC et al., 6th Cir. No. 16-3360, 16-3732. They argue that the MSRB rules violate the First Amendment and exceed the authority of both the SEC and the MSRB. The SEC’s position is that the court does not have jurisdiction to hear the challenge because the SEC did not issue a formal order approving the rule and the rules were only deemed approved in the absence of SEC action. The Republican Parties filed their reply brief on January 26, 2017, arguing, inter alia, that the SEC cannot insulate the rules from review through inaction. The matter is now fully briefed, but the case has not yet been scheduled for argument.
Given the risk of enforcement activity relating to political contributions by participants in the financial services industry, even in the absence of intentional violations of the rules, we recommend that covered investment and municipal advisers, broker-dealers, and their associated persons consider which of the rules apply to their operations and review their compliance policies and procedures, as well as ensure that covered personnel understand their regulatory obligations and firm procedures. Dechert has significant experience in both pay-to-play counseling and pay-to-play enforcement issues and would be happy to provide training or guidance on best practices.