Following its July 22nd unanimous vote in favor of proposing prohibitions on certain “pay to play” practices by investment advisers that seek to manage money for state and local governments, the Securities and Exchange Commission (the “SEC” or the “Commission”) issued a release, on Aug. 3, proposing for comment new Advisers Act Rule 206(4)-5 (the “Proposing Release” or the “Release”), which has the following four components:
- Political contributions — two-year “time out.” An adviser would be prohibited from providing advisory services for compensation to a government client or to an investment pool in which a government entity invests for two years after the firm or its “related persons” makes a contribution to an official of the relevant government entity with authority or influence regarding the selection of an adviser or investment pool;
- Ban on using third parties to solicit government clients. An adviser would be prohibited from providing or agreeing to provide payment to any third party (including a registered broker-dealer) for solicitation of advisory business from any government entity or investment by the government entity into an investment pool managed by the adviser;1
- Ban on solicitation or coordination of contributions. An adviser would be prevented from soliciting from others, coordinating or “bundling” contributions to certain elected officials or political parties where the adviser is providing or seeking government business; and
- Recordkeeping. A registered adviser would be required to maintain certain records of the political contributions made by the adviser and certain of its “related persons.”
During the SEC’s July 22nd open meeting on the proposal, Chairman Mary L. Schapiro stated that the prohibitions are intended to “significantly curtail the corrupting and distortive influence of pay to play practices, including, among other things, campaign contributions made to influence the selection of investment advisers to manage public pension plans and similar government investment accounts.” Chairman Schapiro further noted that, in the ten years since the Commission last considered a curb on pay to play practices, public pension plans have grown to $2.2 trillion in total assets, representing one-third of all U.S. pension assets, and state-sponsored “qualified tuition plans” authorized by Section 529 of the Internal Revenue Code, which were in their infancy in 1999, have grown to more than $104 billion in assets. Given the “substantial size and increased scope and significance of the government plan market,” the proposed rule is intended to, in Chairman Schapiro’s words, level the playing field for all advisers, both large and small, so that they can compete for government contracts based on investment skill and quality of service, not based on political contributions and inappropriate, under-the-table payments.
If the proposed rule is adopted, many registered and unregistered advisers will need to institute policies and procedures pursuant to which they carefully monitor the political contributions, fundraising and other monetary assistance provided by their “covered associates” to political candidates. In addition, private funds will, for the most part, no longer be able to use placement agents or any other type of third-party marketer to solicit advisory business or investments from government entities.
A. Scope of Proposed Rule 206(4)-5
1. Registered and Unregistered Investment Advisers
The proposed rule would apply to SEC-registered advisers, as well as advisers currently exempt from SEC registration pursuant to Advisers Act Section 203(b)(3), by virtue of their having had fewer than 15 clients during the past 12 months and not having held themselves out to the public as investment advisers.2 It would not apply to state-registered advisers or advisers within the intrastate exemption to SEC registration — categories deemed unlikely to have state or municipal government clients. Government “clients,” for purposes of the proposed rule, would be defined broadly to include all state and local government sponsored investment programs or plans, including but not limited to retirement plans and qualified tuition plans established under Section 529 of the Internal Revenue Code.
2. Covered Investment Pools
In addition to applying to advisers that provide advisory services directly to government clients, the proposed rule would apply to advisers to “covered investment pools” in which government entities invest or are solicited to invest, generally defined as (a) any investment company as defined in Section 3(a) of the Investment Company Act of 1940 (“Company Act”); or (ii) any company that would be an investment company under that section but for the exclusion provided under Section 3(c)(1), Section 3(c)(7) or 3(c)(11) of the Company Act3 – categories that include certain mutual funds, hedge funds, private equity funds and venture capital funds. For purposes of the proposed rule’s prohibitions, an adviser to a covered investment pool in which a government entity invests or is solicited to invest generally is treated as though the adviser is providing or is seeking to provide investment advisory services directly to the government entity.4
The SEC is proposing an exemption from the two-year time out provisions for advisers to publicly offered SEC-registered investment companies because the agency has less concern that such advisers would be motivated to participate in pay to play activities and also because government entities may invest in such mutual funds on a temporary basis without the adviser even being aware of the investment. Advisers to such mutual funds would be subject to the rule’s two-year time-out provisions only if the fund is included as an investment option in a plan or program of a government entity, such as a 529 tuition savings plan.
B. Background and Source of Proposed Rule
As mentioned above, while the Commission proposed “pay to play” prohibitions with respect to advisers in 1999, the current rule proposal is modeled on Rules G-37 and G-38 of the Municipal Securities Rulemaking Board (“MSRB”), which address pay to play practices by broker-dealers in the municipal securities markets.5 The Proposing Release notes that following the adoption of these rules, the SEC became “increasingly concerned that the very success of the rule(s) may have caused pay to play practices to migrate to an area not covered by the MSRB rules — the management of public pension plans.” The Release also notes that the SEC and criminal prosecutors have brought a number of actions in recent years charging investment advisers, broker-dealers, government officials and “placement agents” with participating in pay to play schemes. Additional impetus for the rule proposal comes from the written requests to the Commission by public officials with oversight of public pension funds urging a prohibition on advisers’ participation in pay to play practices, including a prohibition on the use by advisers of placement agents (or other types of consultants) to help secure government business.
The statutory basis for the proposed rule is Section 206 of the Advisers Act, which, in pertinent part, prohibits an investment adviser from committing fraud or engaging in any fraudulent practice with respect to any client or prospective client and authorizes the SEC to adopt prophylactic rules reasonably designed to prevent fraudulent, deceptive and manipulative practices by advisers. The Proposing Release notes that Section 206 establishes a “federal fiduciary standard governing the conduct of advisers,” which is violated when an adviser uses political contributions to bypass the merit-based selection processes established by public pension plans, thereby creating a conflict of interest between the adviser (whose interest is in being selected) and its prospective client (whose interest is in obtaining the best available management services.)6 It further notes that “pay to play practices are rarely explicit and often hard to prove, which makes a prophylactic rule particularly appropriate.”
C. Prohibited “Pay to Play” Practices
1. Political Contributions — Two-Year “Time Out”
Under the proposed rule, investment advisers would be prohibited from providing advice for compensation to a government entity for two years after the firm or any of its “covered associates” makes a “contribution” to an “official” of that “government entity.” The concept of “covered associates,” similar to the concept of “municipal finance professionals” under MSRB Rule G-37, is intended to encompass those individuals associated with an advisory firm who have a direct economic stake in the business relationship with the government client, and thus includes: (a) the adviser’s general partners, managing members, executive officers and other individuals with a similar status or function; (b) any employee of the adviser who solicits government entity clients; and (c) any Political Action Committee (“PAC”) controlled by the adviser or any of the adviser’s covered associates.
“Contribution,” “official” and ”government entity” are defined substantially the same as under MSRB Rule G-37. A contribution is any gift, subscription, loan, advance, deposit of money, or anything of value provided for the purpose of influencing an election for federal, state or local office, including payments for debts incurred in such an election and payment of transition or inaugural expenses incurred by a successful candidate for state or local office.7 Government entities include all state and local governments, their agencies and instrumentalities, and all public pension plans and other collective government funds. An official is any incumbent, candidate or successful candidate for public elective office of a government entity if (a) the office is directly or indirectly responsible for, or can influence the outcome of, the adviser selection process; or (b) the office has the authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the selection process.
It is important to note that during the two-year “time out,” advisers who have made contributions covered by the proposed rule are prohibited from receiving compensation for providing advisory services to the relevant government client. The SEC notes that this approach is intended to avoid the adviser abandoning a government client after making a political contribution covered by the rule and that in such a circumstance, the adviser likely would be obligated to provide uncompensated advisory services to the client for a reasonable period of time necessary to ensure an orderly transition to a new adviser. Depending upon their bargaining power, government clients could negotiate for provisions in their advisory contracts that would obligate an adviser who becomes subject to the two-year “time out” to continue providing advisory services for the entire remaining term of the contract on an uncompensated basis.
a. Application to Covered Investment Pools
If a government entity is an investor in a covered investment pool at the time that a political contribution triggering the two-year time out is made, the proposed rule would require that the adviser to the pool forego any compensation, including reimbursement of costs, related to the assets invested by that government entity. The Proposing Release notes that in the case of some types of private funds, the adviser could waive or rebate fees and any performance allocation or carried interest or even seek to cause the investor to redeem its investment. However, in the case of other types of private funds or publicly offered mutual funds, there may be practical obstacles that make it extremely difficult, if not impossible, to enforce the ban on receipt of compensation from the relevant government entity.
b. “Look Back” Provision
Under the proposed rule, a covered associate whose political contribution triggered the two-year time out for his advisory firm would trigger a two-year time-out for any new firm that he or she joined within two years of making the triggering contribution.8 Consequently, prior to bringing in any covered associate, an adviser would have to “look back” at whether, during the previous two years, that individual made any political contributions covered by the proposed rule. This “look back” provision, which is virtually identical to that in MSRB Rule G-37, is intended to prevent advisers from circumventing the rule by hiring individuals who made contributions to the relevant government officials (and presumably acquired influence in the adviser-selection process) while at previous firms.
c. Exception for De Minimis Contributions
The proposed rule contains a de minimis exception modeled on Rule G-37 that allows for each covered associate who is an individual to make aggregate contributions of up to $250 per election to a candidate for which the associate is entitled to vote without triggered the two-year time out. Primary and general elections would be considered separate elections for purposes of this exception; thus, a contribution of up to $250 could be made in each without triggering the time out.
d. Exception for Returned Contributions
In order to address situations in which an adviser triggers the time out inadvertently, generally adopting the “automatic exemption” provision of Rule G-37, the proposed rule provides an exception to the time out if all of the following conditions are met: (1) the adviser discovers the triggering contribution within four months of it having been made; (2) within 60 days of discovery, the adviser returns the contribution to the contributor; and (3) the contributor made the contribution to an official other than one for whom he or she was entitled to vote at the time. An adviser would be entitled to rely upon this exception no more than twice during any 12-month period and no more than once for the same covered associate regardless of time period.
e. SEC Exemptive Authority
Under the proposed rule, an adviser could apply for an order from the Commission exempting it from the two-year time-out where the adviser discovers triggering political contributions after-the-fact and where imposition of the time-out is not necessary to achieve the rule’s intended purpose. The Proposing Release notes that, in determining whether to grant an exemption, the Commission would consider a number of factors, including but not limited to: public interest and investor protection concerns; whether, prior to the contribution, the adviser had in place policies and procedures reasonably designed to prevent violations; whether, after discovery of the contribution, the adviser took all available steps to obtain a refund and whether, since discovery, the adviser has implemented remedial measures to prevent a recurrence.9
2. Ban on Using Third Parties to Solicit Government Clients
The proposed rule would prohibit advisers and their covered associates from providing or agreeing to provide “payment” to any person to solicit a government entity for investment advisory business unless such person is: (a) a “related person” of the investment adviser or if the related person is a company, an employee of that related person; or (b) any of the adviser’s employees, general partners, LLC managing members, executive officers or other persons with similar status or function. This ban would extend to consultants, cash solicitors, and marketing agents of every type, including registered broker-dealers. “Payment” is defined as any gift, subscription, loan, advance or deposit of money or anything of value, including but not limited to a “finder’s fee” or payments to third-party consultants for performing various services such as attending or sponsoring conferences intended to attract government clients. “Solicit” is broadly defined to mean (i) with respect to advisory services, communications intended to obtain or retain a client; and (ii) with respect to contributions or payments, communications for the purpose of arranging the contribution or payment.
The impetus for this far-reaching ban, which is modeled after the ban that was incorporated into Rule G-38 in 2005, is two-fold: first, the Commission is concerned that advisers would use consultants and solicitors to circumvent the proposed rule’s prohibition against political contributions; and second, the Commission believes that simply extending the ban on political contributions to third parties would not work due to the inability of advisers to control the third parties’ use of the funds paid to them by advisers. The Proposing Release notes that third-party consultants and solicitors have played a role in each of the recent pay to play enforcement actions brought by the Commission against investment advisers and that New York and other jurisdictions either have instituted, or are considering instituting, broad prohibitions against the use of third-party marketers.
If adopted, this part of the proposed rule would dramatically impact the manner in which private funds solicit advisory business from government entities because it would preclude advisers from entering into any arrangement to compensate any third party, including a registered broker-dealer, to market the adviser’s services to such entities, including arrangements under which prime brokerage firms provide fund marketing to government entities as part of the prime brokerage services for which they are compensated by their fund clients. Significantly, the ban does not extend to an adviser’s use of a parent company, subsidiary or sister company or any of the employees of such “related persons” to solicit government entities for compensation in recognition of the “efficiencies [that may be achieved] in allowing advisers to rely on these particular types of persons to assist them in seeking clients.” Thus, the proposed rule, if adopted, may stimulate the acquisition or creation of more substantial internal marketing operations by fund complexes.
3. Prohibition on Solicitation/Coordination of Contributions
The proposed rule would contain provisions, modeled after those incorporated into Rule G-37 in 2005, which prohibit an adviser and its covered persons from: (a) soliciting any person or PAC to contribute to any government entity to which the adviser is providing or seeking to provide advisory services; (b) coordinating contributions to any prospective or current government client; (c) “bundling” contributions from employees or others to any prospective or current government client; and (d) making or coordinating contributions to any prospective or current government client through a third party, such as a “gatekeeper” — typically a pension consultant that distributes or directs contributions to elected officials or candidates and may arrange “swaps” of contributions between elected officials to obscure the significance of the contribution or circumvent plan restrictions on contributions to trustees.10
D. Recordkeeping Requirements
Also proposed in the same Release are amendments to Advisers Act Rule 204-2, which are modeled after the MSRB recordkeeping rule, requiring that SEC-registered investment advisers that have or seek government clients, or provide advisory services to covered investment pools in which government entities invest or are solicited to invest, keep certain records of contributions made by the adviser and its covered associates. Among the required records are: all government entities for which the adviser or any of its covered associates is providing or seeking to provide investment advisory services, or which have been solicited to invest in any covered investment pool managed by the adviser; and all direct or indirect contributions or payments made by the adviser or any of its covered associates to an official of a government entity, a political party of a state or political subdivision or a PAC. These records would have to be retained from the effective date of the rule forward.
E. Request for Comments
The period for submitting comments on the Rule Proposal expires on Oct. 6, 2009. Letters of comment may address any aspect of the Rule Proposal and may suggest alternative approaches to regulating pay to play practices. In addition, the SEC, through the Proposing Release, specifically requested comment on a wide variety of issues relating to various provisions of the rule. These topics include:
- Whether the rule should apply to advisers who are exempt from SEC registration under Section 203(b)(3) because they have fewer than 15 clients and do not hold themselves out to the investing public;
- Whether the rule should be modeled on MSRB Rules G-37 and G-38, or on alternative models;
- Whether, instead of adopting a new rule prohibiting certain pay to play practices, the Commission should instead require an executive officer of each adviser, or its compliance director, to certify annually that the adviser and its covered associates did not engage in pay to play practices;
- Whether two years is the appropriate length of time for the time-out provision;
- Whether the definition of covered associates is too narrow or too broad;
- Whether a shorter look-back period would serve the goal of preventing circumvention through the use of roving covered associates;
- Whether the de minimis exception to the ban on political contributions should be adjusted for inflation; and
- Whether the ban on payments to third-party marketers is the appropriate means to deter pay to play practices.