On August 3, 2009, the U.S. Securities and Exchange Commission (the “SEC”) published proposed Rule 206(4)-5 entitled “Political Contributions by Certain Investment Advisers,” as well as certain amendments to Rules 204-2 and 206(4)-3 under the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”).1 Proposed Rule 206(4)-5 would address “pay to play” practices by certain investment advisers that provide, or are seeking to provide, investment advisory services to government entity clients and to certain covered investment pools in which a government entity invests. The proposed rule would prohibit an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The proposed rule would also prohibit an adviser from providing or agreeing to provide payment to any third party for a solicitation of advisory business from any government entity, or for a solicitation of a government entity to invest in certain covered investment pools, on behalf of such adviser. Additionally, the proposed rule would prevent an adviser from coordinating or soliciting from others contributions to certain elected officials or candidates or payments to certain political parties. The proposed amendment to Rule 204-2 under the Advisers Act would require registered investment advisers to maintain certain records of the political contributions made by the adviser or certain of its executives or employees.
Advisers Subject to Rule 206(4)-5. Importantly, the proposed rule would apply to any investment adviser registered (or required to be registered) with the SEC, or unregistered in reliance on the “private adviser” exemption available under Section 203(b)(3) of the Advisers Act. However, proposed Rule 206(4)-5 would not apply to investment advisers registered with state securities authorities and unregistered investment advisers relying upon the intrastate exemption available under Section 203(b)(1) of the Advisers Act.
“Pay to Play” Restrictions. Proposed Rule 206(4)-5 would make it unlawful for an adviser to receive compensation for providing investment advisory services to a “government entity”2 for a period of two years after the adviser or any of its “covered associates”3 makes a “political contribution”4 to an official (which includes an incumbent, a candidate, a successful candidate, or an executive or legislative officer) of a government entity that is in a position to influence the award of advisory business. Importantly, investment advisers making contributions covered by proposed Rule 206(4)-5 would not be prohibited from providing advisory services to a governmental client, even after triggering the two-year time out. Instead, such an adviser would be prohibited from receiving compensation for providing advisory services to the government client during such time out. Such an investment adviser would, however, be obligated to continue providing uncompensated investment advisory services for a reasonable period of time until the government entity finds a successor adviser to ensure that the adviser’s withdrawal did not harm the client.
Under proposed Rule 206(4)-5, the two-year time out would continue in effect even after the covered associate who made the triggering contribution left the advisory firm. In addition, at the time of hiring an employee, an investment adviser would be required to “look back” for the requisite time period to determine if it would be subject to any restrictions under the rule due to such employee’s contributions. These provisions would prevent advisers from circumventing the rule by channeling contributions through departing employees, or by influencing the selection process by hiring persons who have made political contributions.
Two exceptions to the proposed rule are contemplated: (i) de minimis contributions by covered associates to officials that they are entitled to vote for of $250 or less per election; and (ii) returned contributions that result in an inadvertent trigger of the ban, where the initial contribution was made by a covered associate who was not entitled to vote for the recipient of the contribution and which does not exceed $250 to any one official per election. This second exception would only be available when the investment adviser discovered the contribution within four months of the date of the contribution and caused it to be returned promptly. It will be limited in use to no more than twice per 12-month period by an adviser and no more than once per covered associate, regardless of the time period.
Ban on Use of Placement Agents. Proposed Rule 206(4)-5 would prohibit an investment adviser or any of its covered associates from providing or agreeing to provide, directly or indirectly, payment5 to any third party solicitor (i.e., placement agents, finders, pension consultants) to solicit6 government entities for investment advisory services. This prohibition on payments to third party solicitors would not apply to solicitations on behalf of an investment adviser by a person who is a “related person”7 of the adviser, any of the related person’s employees if the related person is a company, or any employees, executive officers, or partners of the investment adviser. The SEC indicated that it is proposing to prohibit only third party solicitors, because they pose “a significant threat to investor protection.” In contrast, the SEC indicated that they recognized that there may be efficiencies in allowing advisers to rely on related persons to assist them in seeking clients.
Restrictions on Soliciting and Coordinating Contributions and Payments. The proposed rule would prohibit an investment adviser or its covered associates from soliciting others to make, or from coordinating, any contribution to any official of a government entity to which the adviser is providing or seeking to provide investment advisory services. It would also prohibit the solicitation or coordination of 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. These provisions would ban such activities as “bundling,” where a person acting on an adviser’s behalf combines smaller contributions or payments from employees of the investment adviser or others to create one large contribution or payment, and “gatekeeping,” an arrangement where political contributions are directed by an intermediary who distributes these contributions to elected officials or candidates. In addition, the proposed rule would also prohibit acts done indirectly, which, if done directly, would result in a violation of the rule. The SEC noted that pay to play practices are rarely explicit and often hard to prove, making a prophylactic rule particularly appropriate.
Application of Rule 206(4)-5 to Investment Funds. Under proposed Rule 206(4)-5, each of the pay to play prohibitions (with one exception8) would be equally applicable to an investment adviser that manages assets of a government entity through the government entity’s investment (or solicitation to invest) in a “covered investment pool” (i.e., private equity funds, hedge funds, venture capital funds and mutual funds) managed by that adviser. A “covered investment pool” is defined as: (i) any investment company as defined in Section 3(a) of the U.S. Investment Company Act of 1940, as amended (the “Investment Company Act”); or (ii) any company that would be an investment company but for the exclusion provided from that definition by Section 3(c)(1), Section 3(c)(7) or Section 3(c)(11) of the Investment Company Act. If a government entity is an investor in a covered investment pool at the time the contribution triggering a twoyear time out is made, the proposed rule would require the adviser to forgo any compensation related to the assets invested or committed by that government entity. In the case of a private fund, the adviser typically could waive or rebate the related fees and any performance allocation or carried interest. The adviser may also seek to cause the pooled investment vehicle to redeem the investment of the government entity. For many private funds, such as private equity funds, it may not be possible for a government entity to withdraw its capital or cancel its commitment without harm to the other investors.
Exemptions. The proposed rule would allow advisers to apply to the SEC for an order exempting them from the two-year compensation prohibition. The SEC’s considerations in deciding whether or not to grant this exemption would include: (i) whether the exemption is necessary or appropriate and consistent with investor protection; (ii) whether the adviser implemented reasonable compliance measures to prevent violations, had no actual knowledge of the contribution, and after learning of the contribution, took all reasonable steps to obtain a return of the contribution and implement remedial measures; (iii) whether at the time of contribution the contributor was a covered associate or employee of the adviser; (iv) the timing and amount of the contribution; (v) the nature of the election (e.g., federal, state, or local); and (vi) the apparent intent or motive in making the contribution.
Record keeping. The SEC also proposed amendments9 to Rule 204-2 of the Advisers Act which would require registered investment advisers to keep, at a minimum, certain records enabling the SEC to determine the adviser’s compliance with Rule 206(4)-5. These records would include: (i) the names, titles, and business and residence addresses of all covered associates of the investment adviser; (ii) details of all government entities for which the investment adviser or any of its covered associates is providing or seeking to provide investment advisory services; (iii) details of all government entities to which the investment adviser has provided investment advisory services, along with any related covered investment pools to which the investment adviser has provided investment advisory services and in which the government entity has invested in the past five years; and (iv) all direct or indirect contributions or payments made by the investment adviser or any of its covered associates to an official of a government entity or a political party of a state or locality or a political action committee.
Effective Date. The proposed rule and rule amendments will become effective on the date of adoption. The SEC is seeking public comments on the proposals by October 6, 2009.