The date to comply with the SEC's “pay-to-play” rule, Rule 206(4)-5, is fast approaching. Rule 206(4)-5 applies to all investment advisers registered, or required to be registered, with the SEC, as well as investment advisers currently exempt from federal registration under the private adviser exemption.
Investment advisers subject to rule 206(4)-5 must comply with the rule on March 14, 2011. Investment advisers may no longer use third parties to solicit government business except in compliance with the rule on September 13, 2011. Investment advisers to registered investment companies that are investment options of a plan or program of a government entity must comply with the rule by September 13, 2011.
To ensure compliance with the rule, investment advisers should adopt and implement policies and procedures reasonably designed to prevent violations. The policies and procedures should cover the provisions discussed below, and address remedial actions to be taken if violations occur. At a minimum, remedial action should include taking all reasonably available steps to cause the contributor involved in making the prohibited contribution to obtain a return of the contribution.
In drafting pay-to-play policies and procedures, it is important to understand the primary object of the rule. Namely, the rule is designed to prevent investment advisers from seeking to influence government officials' awards of advisory contracts by making or soliciting political contributions to those officials (pay-to-play practices). Pay-to-play practices could, for example, lead a political official to choose an investment adviser with higher fees or inferior investment performance because the adviser contributed funds to the official's election campaign. To combat these pay-to-play practices, the rule does not ban or limit the amount of political contributions an adviser or its covered associates can make, but imposes a limited “time-out” on conducting advisory business for compensation with a government client after a contribution is made.
To combat pay-to-play practices, the rule defines “contributions” broadly to include any gift, subscription, loan, advance, or deposit of money or anything of value made for: (1) the purpose of influencing any election for federal, state, or local office; (2) payment of debt incurred in connection with any such election; or (3) transition or inaugural expenses of the successful candidate for state or local office. The rule also includes a provision that prohibits any indirect action that would be prohibited if the same action was done directly.
With the object of the rule and its broad application in mind, the policies and procedures should set forth an explanation of the applicable limitations and the related procedures to be followed. The following is a brief summary of the restrictions imposed by the rule:
- Restrictions on the Receipt of Advisory Fees. The rule prohibits the receipt of compensation by an investment adviser from a government entity for the adviser providing investment advisory services for two years following a contribution to any official of that government entity. This prohibition also applies to any contribution made by a covered associate of the investment adviser, subject to a de minimis exception (namely, contributions from natural persons of $150 per election, or $350 per election if the contributor is eligible to vote in the election).
- Restrictions on Payments for the Solicitation of Clients or Investors. The rule prohibits an investment adviser and any covered associated from providing or agreeing to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of the adviser unless such person is a regulated person or is an executive officer (or a person with a similar status or function) or employee of the adviser.
- Restrictions on the Coordination or Solicitation of Contributions. The rule prohibits an investment adviser and any covered associate from coordinating, or soliciting any person or political action committee to make, any: (1) contribution to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services; or (2) payment 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 following are some sample procedures that may be implemented to ensure compliance with the rule and its limitations:
- Political contributions by the investment adviser or employees of the adviser to politically connected individuals or entities with the intention of influencing such individuals or entities for business purposes should be prohibited.
- If an employee or any affiliated entity is considering making a political contribution to any state or local government entity, official, candidate, political party, or political action committee, the potential contributor should be required to seek pre-clearance from the investment adviser's chief compliance officer.
- The chief compliance officer should meet with any individuals who are expected to become “covered associates” to discuss their past political contributions.
- Donations by the investment adviser or employees to charities with the intention of influencing such charities to become clients should be prohibited.
- Employees should be encouraged to notify the chief compliance officer if they perceive an actual or apparent conflict of interest in connection with any charitable contribution.
- Employees should be required to obtain written pre-approval from the chief compliance officer prior to running for any public office.
- Employees should not be allowed to hold a public office if it presents any actual or apparent conflict of interest with the investment adviser's business activities.