On August 3, 2009, the Securities and Exchange Commission (the "SEC") published proposed amendments to the Investment Advisers Act of 1940 (the "Advisers Act") to eliminate perceived "pay-to-play" practices by investment advisers providing advisory services to government clients.[1] The proposed rules would apply to registered investment advisers, as well as investment advisers and fund managers that are exempt from registration under the "private adviser exemption" in Section 203(b)(3) of the Advisers Act. This would include many private equity funds, venture capital funds, hedge funds, real estate funds, and structured finance vehicles.

The proposed rules would, among other things, prohibit an investment adviser from providing advisory services for compensation to a government entity (including managing a fund in which a government entity invests) for two years after making a contribution to certain officials or candidates, and from paying a third party to solicit business from any government entity on behalf of such adviser.

"Pay-to-Play" Restriction

The proposed rules would prohibit investment advisers from providing advice for compensation to a government entity, including government-sponsored pension and other plans, within two years after a direct or indirect contribution to an "official" of the government entity has been made by the investment adviser or any of its "covered associates."

An "official" includes an incumbent or candidate for a government office that is directly or indirectly responsible for, or can influence the outcome of, the selection of an investment adviser, or that has authority to appoint any person who is directly responsible for or can influence the outcome of the selection of such an investment adviser. The proposed rules do not define "influence," which could be interpreted to run up the chain from lower-level state officials to a gubernatorial candidate.

The term "covered associates" includes the investment adviser's general partners, managing members, executive officers, and other individuals with similar status or function that perform investment advisory services or solicitations for the adviser or that directly or indirectly supervise executive officers that conduct such activities; any employee who solicits advisory clients for the adviser; and any political action committee controlled by the adviser or its covered associates.

Once triggered, the two-year prohibition will continue in effect even if the covered associate who makes the contribution leaves the employ of the investment adviser. Similarly, the prohibition would be attributed to any other investment adviser that employs or engages the person who made the contribution for two years after the date the contribution was made. The broad definition of "covered associates" and the look-back period for new hires would create new monitoring and hiring burdens for investment advisers, as mistakes would potentially cause dire consequences.

The proposed rules do not prohibit the provision of advisory services during such two-year period, only payment of compensation for providing such services. This approach mirrors that of rules G-37 and G-38 of the Municipal Securities Rulemaking Board, which address "pay-to-play" practices in the municipal securities market. An underwriter of municipal securities that becomes subject to a two-year time-out may elect not to perform underwriting services for a particular government entity until the two-year period lapses. However, an investment adviser that triggers a two-year time-out may already have funds under management and/or commitments from the relevant government entity, in which case the adviser could be forced to provide services without compensation.

The proposed rules also do not explicitly define "compensation"; however, they suggest that a private investment fund may be required to waive or rebate any fees, including any performance allocation or carried interest, related to the government entity investment. The proposed rules also note that investment advisers may need to cause the redemption of the government entity investment to avoid providing uncompensated services, but they provide no means to do so and acknowledge that a redemption or commitment cancellation may cause harm to the investment vehicle and its other investors. If these or similar rules are adopted, investment advisers will have to consider amending their advisory and investment contracts with government entities to address proper remedies and exit strategies in the event that a two-year time-out is triggered, as well as revising disclosures regarding redemptions of government entity interests.

Ban on Use of Solicitation Firms

The proposed rules ban the use of third parties, including placement agents, to solicit government entities for investment advisory services. This proposed ban would make it more difficult for private investment funds to solicit public pension plans, which historically have found such funds to be significantly appealing investment options. Because established "brand-name" funds and other large funds have existing relationships with the managers of these public pools of capital and can more easily bring solicitation services in-house, the likely result would be an uneven playing field disadvantaging smaller funds and newer funds. This in turn would likely limit the investment choices of pension plan officials, who may not have the time to meet and sufficiently investigate all potential investment opportunities.

The SEC proposed similar "pay-to-play" rules in 1999 that did not include a ban on the use of third-party solicitors. Instead, the 1999 proposal attributed the actions of third-party solicitors to the investment adviser, such that a tainted payment by the solicitor would result in a two-year time-out for the adviser. Several commentators on the 1999 proposal were concerned with monitoring third-party compliance. In its request for comments, the SEC cites this monitoring concern as the main reason for its proposed ban and invites comments specifically addressing whether its 1999 attribution rule would be a better alternative.

Other Provisions

The proposed rules also prohibit an adviser and its covered associates from soliciting from others or coordinating contributions to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services, or payments to a political party of a state or locality where the adviser is providing or seeking to provide investment advisory services to a government entity.

The proposed rules, however, contain a de minimis exception for individual covered associates to make aggregate contributions of $250 or less per election if they are entitled to vote for the official or candidate. There is an additional exception for contributions by individual covered associates that do not fall within the de minimis exception if the contribution is discovered by the adviser within four months after the contribution is made and the funds are returned to the contributor within 60 days after the adviser learns of the triggering contribution, although this exception can only be used twice per 12-month period and can never be used more than once for the same covered associate. An investment adviser would also be able to apply to the SEC for an order to exempt it from the two-year compensation ban where the adviser discovers a triggering contribution after it has been made and where the imposition of the prohibition is unnecessary to achieve the intended purposes of the rule.

In connection with monitoring compliance, the proposed rules also impose new recordkeeping requirements on investment advisers registered or required to be registered with the SEC that either have government clients or provide investment advisory services to a covered investment pool in which a government entity investor invests or is solicited to invest. Such advisers would need to make and keep records of contributions made by them and their covered associates. If the U.S. Treasury Department's recently proposed Private Fund Investment Advisers Registration Act of 2009[2] is enacted into law, most advisers to private funds would be required to register as investment advisers and would be subject to these recordkeeping requirements. As a result, non-U.S. advisers to private pools may choose to avoid investments from U.S. government entities to avoid these regulatory burdens.

The proposed rules, as currently drafted, including the prohibition of contributions and the recordkeeping requirements, do not have a transition period and would be effective from the date that the rules are officially enacted.

Comment Period

Comments on the proposed rules are due by October 6, 2009. Comments may be submitted electronically using the SEC's online comment form at

http://www.sec.gov/rules/proposed.shtml or the Federal eRulemaking Portal at http://www.regulations.gov/, or via email to rule-comments@sec.gov (with "File Number S7-18-09" in the subject line). Paper comments to the SEC should be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All submissions should refer to "File Number S7-18-09."