The SEC has adopted new requirements to prevent "pay to play" relationships between investment advisers and elected officials who control or influence the awarding of investment advisory business. "Pay to play" refers to the practices of making contributions to elected officials to attempt to influence the awarding of contracts to manage public pension plan assets and other government investment accounts. Under new Rule 206(4)-5 of the Investment Advisers Act of 1940 (the "Investment Advisers Act"), investment advisers that are registered, or required to register, with the SEC, or which are exempt from registration in reliance on Section 203(b)(3) of the Investment Advisers Act (commonly known as the "private adviser exemption")1, may not receive compensation for performing advisory services for a government entity for two years after making direct or indirect contributions to government officials who have the power to influence the awarding of investment advisory business.
Key elements of Rule 206(4)-5 include:
- Two-year time out on compensation for advisory services after a political contribution by the adviser or a "covered associate" of the adviser
- Prohibition on solicitation of political campaign contributions from any person or political action committee
- Restrictions on third-party solicitations of potential government clients; prohibition on paying a solicitor of government clients unless the solicitor is registered as a broker-dealer or investment adviser
In addition, the SEC has amended Investment Advisers Act Rule 204-2, the adviser record keeping rule, to require registered investment advisers to keep detailed records in connection with political contributions if the adviser has government clients or if it provides investment advisory services to a "covered investment pool" in which a government entity invests.2 The SEC also amended Rule 206(4)-3, the "solicitor" rule, to make clear that solicitation activities involving a government entity are subject to the additional limitations of Rule 206(4)-5.
Rule 206(4)-5 and the amendments to Rule 204-2 and Rule 206(4)-3 are effective September 13, 2010, with a compliance date for most provisions of March 14, 2011. However, the requirements for third-party solicitation are effective September 13, 2011. The record keeping requirements for any registered investment company which is a "covered investment pool" are effective September 13, 2011.
I. Two-Year Time Out on Compensation for Advisory Services after a Contribution
An investment adviser is prohibited from receiving compensation for providing investment advisory services to a government entity for a two-year period after the adviser or any of its "covered associates" makes a political contribution (over a de minimis amount) to an incumbent, candidate, or successful candidate for a public office that is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser. "Covered associates" include any general partner, managing member or executive officer, or other individual with a similar status or function; any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee and any political action committee ("PAC") controlled by the investment adviser or by any of its covered associates. An investment adviser to a covered investment pool in which a government entity invests in or is solicited to invest is treated as though the adviser is providing services directly to the entity.
- De Minimis Exception per Election
Covered associates who are natural persons may each contribute an aggregate of $350 per election to an elected official or candidate for whom the covered associate is entitled to vote without triggering the two-year time out. They may also each contribute up to $150 per election to an elected official or candidate for whom they are not entitled to vote (such as an out-of-state candidate) without triggering the two-year time out. Primary and general elections are considered separate elections under the rules.
- "Look Back" Period for New Covered Associates
Rule 206(4)-5 specifically includes within its scope contributions that any new covered associate of an adviser makes within two years of assuming such status. When an employee becomes a covered associate, the adviser must "look back" in time to that employee's contributions to determine whether the time out period applies to the adviser. However, if a covered associate does not solicit clients, then the look back applies only to the six month period prior to becoming a covered associate. Advisers will have to be very careful when vetting new employees or promoting existing employees to ensure that political contributions made in the past will not result in the adviser violating the rule and thereby losing the ability to receive compensation for services. In addition, advisers engaging in business combinations or other transactions that result in new covered associates will need to conduct due diligence to determine whether the transaction would inadvertently result in a technical violation of the rule.
- Limited Exception for Returned Contributions
Rule 206(4)-5 allows an adviser to remedy an inadvertent political contribution by a covered associate of under $350. An adviser that discovers an inadvertent contribution may, within four months of the date of the triggering contribution and within 60 days of learning of the contribution, ask the recipient to return the contribution. An adviser may utilize this exception no more than once per each covered associate, and not more than two or three times in total within a twelve month period, depending on whether the adviser has more than fifty employees.
II. Prohibition on Solicitation and Coordination of Campaign Contributions
The new rules contain provisions designed to prevent advisers from circumventing the rules by "bundling" large numbers of small contributions. Advisers and their covered associates generally may not solicit or coordinate contributions to an official of a government entity to which the investment adviser is seeking to provide investment advisory services. Advisers and their covered associates also are generally prohibited from soliciting or coordinating payments to a political party of a state or locality where the investment adviser is providing or seeking to provide investment advisory services to a government entity.
III. Restrictions On Third-Party Solicitations of Potential Government Clients
Rule 206(4)-5(a)(2) prohibits advisers from paying third parties to solicit government clients on the adviser's behalf unless the third party is covered by the pay to play rules or a substantial equivalent. Investment advisers and their covered associates generally may not pay third parties, such as placement agents, to solicit government entities for advisory business unless such third parties are themselves registered broker-dealers or investment advisers regulated by pay to play rules of the SEC or of a registered national securities association. Note that an adviser that currently does not have government entity clients is subject to this provision if it solicits such clients or agrees to pay a third party solicitor for solicitation activities.
Stating that it cannot anticipate all of the way advisers and officials may structure arrangements in an attempt to avoid the new rules' prohibitions, the SEC included a catch-all provision in Rule 206(4)-5(d) making it unlawful for an investment adviser or covered associate to do anything indirectly which, if done directly, would violate the rule. For example, an adviser cannot funnel payments through third parties such as consultants, attorney, family members, friends or affiliated companies as a means to circumvent the rule's prohibitions.
The SEC has amended its existing record-keeping requirements under Rule 204-2 to require SEC-registered advisers that have government clients, or advise a covered investment pool in which a government entity invests, to make and keep records of contributions that the adviser and its covered associates make to government officials and candidates and of payments to state or local political parties or PACs. While only advisers with government entity clients are required to keep records of contributions, advisers that solicit such business or hold themselves out to such clients would be wise to set up policies and procedures and maintain records so they are in a position to verify compliance with the rule if they take on a governmental client. Advisers must also keep records with respect to third party solicitors. The SEC will incorporate a review of the new records in its examination program.
Rule 206(4)-5(e) allows for the SEC to provide an exemption to an adviser from the prohibition on receipt of compensation that would otherwise violate the rule. The SEC included this provision to allow for situations where the adviser discovers contributions "after the fact" that trigger the compensation ban, when the prohibition is unnecessary to achieve the rule's intended purpose. The rule sets out a number of factors that the SEC will consider in determining whether to grant an exemption, including the contributor's status and motives, the nature of the election, and whether the adviser (i) had policies and procedures reasonably designed to prevent violations, (ii) had knowledge of the contribution or (iii) took remedial steps to obtain a return of the contribution and other preventative measures as appropriate. Note that Section 206A of the Investment Advisers Act provides broad exemptive authority to the SEC to conditionally or unconditionally exempt persons or transactions from the Advisers Act and rules thereunder. Presumably an adviser seeking relief from Rule 206(4)-5 also could invoke this provision.
Advisers that do business with or seek business from governmental entities will need to incorporate the new restrictions and requirements into their compliance programs, educate employees, and ensure that appropriate records are set up, maintained, and reviewed. Consequences of violating Rule 206(5)-4 are potentially severe: loss of income for advisory services; possible need to seek exemptive relief from the SEC, and the risk of SEC enforcement action. The March 14, 2011 deadline for compliance is relatively short, so advisers should proceed promptly.